With the Reserve Bank pausing on rate cuts in the past two policies, is the period of gilt rallies over? One way to gauge this is to look at portfolios of dynamic bond funds. These schemes aim to play on interest rate cycles and ride bond price rallies in falling rate cycles.
Going by their portfolios, however, it appears that dynamic bond funds are split in their views on the potential in bond price rallies. Government bonds are the typical instruments that funds use to benefit from rate cuts. Going by changes in this exposure, several funds seem to be limiting their play on the rate cycle, even as a good number are increasing exposure to capture any price rallies. Here’s more on this trend and what it means for investors.
On the whole, dynamic bond funds are becoming comparatively less focused than they were last year on duration as a strategy. The peak level of government bond exposure was in November, just before the December monetary policy, when the Reserve Bank first paused on rates after a series of cuts. In November, gilts accounted for 39 per cent of dynamic bond funds’ AUM (assets under management). Aggregate exposure to gilts in January 2020 stood at 34 per cent.
Though generally scaling back on duration, the category, however, still appears to be seeing room remaining for further rallies and price appreciation opportunities. The current exposure, while below the peak, is still higher than December's 32 per cent. Current aggregate gilt levels are at those around August-September last year.
Now, here's the dichotomy – breaking exposures down to individual funds shows a divergence between schemes, with several actually cutting gilt exposure.
A third of the funds have cut gilt holdings between December and January. Some have done this by a significant margin. Aditya Birla Sun Life Dynamic Bond, for example, has almost exited gilts now against the 48.6 per cent in November and 10.2 per cent in December 2019. BNP Paribas Flexi Debt cut down gilt exposure from 64.6 per cent in December to 13.7 per cent now.
Even as these schemes scaled back on their duration strategy, about half the dynamic bond fund universe continued to bet on it, with gilt holdings up by at least two percentage points. For instance, IDFC Dynamic Bond has almost its entire portfolio in gilts and this is higher now than it was in December. Mirae Asset Dynamic Bond hiked exposure by a solid 14 percentage points to 51.2 per cent between December and January. The gilt maturity profiles these funds are using to play the yields, however, do differ.
Still others, though reducing the extent of exposure, continue to have the majority of their portfolios in government bonds, indicating that they remain positive on further price appreciation. DSP Strategic Bond, for instance, saw gilts dropping six percentage points between December and January, but the segment still accounts for 72 per cent of its portfolio.
The difference in fund strategies is similar to that of 2017, where funds markedly deviated in their interest rate calls. While a few funds expected rate cuts to come in that year and aligned their portfolio accordingly, others either shifted out to the accrual strategy or were extremely dynamic in their gilt calls.
At this time, it could be that the uncertainty on the interest rate front has funds divided or treading cautiously. There is a conflicting combination of rising inflation, fiscal deficit, along with an economic growth slump, and transmission of lower policy rates into market rates is still not completely through.
In fact, this last factor could be prompting some funds into taking longer maturities even in corporate bonds. There are funds whose average portfolio maturity, even without gilts, is still long, at 4-5 years and higher. This is through long-maturity corporate bonds and state development loans. Yields on some papers in these funds are still attractive, making them conducive to a simple accrual strategy. Also, lower policy rates gradually trickling down to actual lending rates could help some rallies in corporate bonds too. Bond yields and prices react to possible changes in interest rates even without RBI action.
Divergence notwithstanding, the key takeaway from dynamic bond fund portfolios is that funds expect limited room for a yield rally. While funds do continue with the duration strategy, most are less aggressive now than they were in 2019. The double-digit one-year returns that these funds are sporting, therefore, are unlikely to persist. Expecting such returns and entering these funds today are likely to leave investors disappointed.(The writer is Co-founder, PrimeInvestor)