This mutual fund manager sees money in a beaten-down mutual fund category. What’s the secret?

A low-risk investment option

BPSU are debt schemes that invest at least 80 percent of their money in bonds issued by banks, public sector undertakings and public financial institutions.

Because these schemes invest in bonds sold by PSUs and banks, they are perceived as a low credit-risk investment option. There is no stipulation on the credit ratings of the bonds. Capital market regulator, Securities and Exchange Board of India’s scheme categorization norms, do not restrict the scheme’s duration or the credit rating of the underlying instruments.

But because these funds invest heavily in securities issued by government-owned companies, the securities come with a good credit rating.

Explaining why these funds were punished by the markets in the past one year, Joydeep Sen, Corporate Trainer-Debt, said: “The muted performance of these schemes is an outcome of rising yields. Due to the marked-to-market losses on the bonds held in the portfolios of the schemes, their performance has been lower compared to shorter- duration products.”

Optimism of a turnaround

The big question that most debt fund investors are asking is: Will bond funds make a come back when central banks the world over are trying to rein in inflation by raising interest rates.

To be sure, investors prefer a positive real rate of return (interest rate minus inflation). To maintain a positive real rate of return, interest rates have got to be higher than inflation. Accelerating inflation forces central banks to hike interest rates.

“Globally, interest rates adjusted sharply higher as participants feared aggressive rate hike cycles for a prolonged period of time. However, as major economies, like the US slowed down (with the economy contracting in Q1 and Q2 of CY2022), markets have dialed down rate hike expectations,” says Jain of Canara Robeco AMC.

In India, the monetary policy committee of the Reserve Bank of India (RBI) is expected to deliver fewer rate hikes than what had been expected a few months ago. After a 90-basis point (bp) increase in the repo rate (more is expected in the RBI Monetary Policy on August 5), expectations that the RBI may not be as aggressive on rate hikes make fixed-income investors hopeful.

The rates to watch out for are the bond yields that get traded in the fixed-income markets. Bond markets are usually ahead of RBI.

“Bond market has already adjusted to discount steep rate hikes, which now may not materialise. This gives an opportunity to invest in debt funds, especially Banking & PSU Debt Funds which can be an investment option for the conservative investor,” Jain said.

Bond yields will not rise for much longer because central bankers the world over now are worried about economic growth while attempting to control inflation.

Marzban Irani, Chief Investment Officer-Debt, LIC Mutual Fund, said: “Expect a couple of more hikes in the repo rate, pushing it in the range of 5.5 to 6 percent over six months. Also many corporate entities as of now are borrowing primarily from the banks. Soon they are expected to start borrowing by issuing bonds. Both these factors together will push up yields on PSU bonds to very attractive levels, making them an attractive investment.”

Many of these schemes tend to offer short- and medium- duration portfolios of three to four years. Such schemes are effective in taking exposure to good quality bonds and benefit from falling interest rates.

As of now some of the schemes in this segment are primarily investing in bonds maturing in the near term to avoid a large impact from rising interest rates. However, fund managers may increase the duration after they see yields peaking.

What should you do?

CBPD will be actively managed, with the fund manager attempting to take advantage of interest-rate movements as well as mispricing on the yield curve. The fund manager currently sees value in the 3-5-year segment of government or corporate bond yield curve and, accordingly, the fund is likely to have a medium-term duration.

Timing the market is difficult. Most investors get it wrong. It makes sense to invest now with a minimum three-to- four-year timeframe.

“Stick to schemes that invest in AAA-rated bonds. Some schemes allocate money to low-rated bonds issued by banks to pocket higher yields, but that also means high credit risk,” says Irani.

Initially these schemes may exhibit some amount of volatility if interest rates move up too much too fast. However, medium term investments should fetch you healthy risk-adjusted returns.

Sen says, “Investors keen on three to four year investment and want to stick to good quality bonds should consider investments in banking and PSU debt funds or corporate debt funds.”

Since BPSU funds are open-ended, they are exposed to the risk of selection of individual bonds and active management of duration by the fund manager. If you want to reduce such a risk then you may consider target funds maturing in three to four years. Though these schemes offer you visibility of returns if held till maturity, they do not let you participate in alpha (outperformance) generated by active management of duration by fund managers and also make you look for alternative investment strategy at maturity.

Gains on units of a banking and PSU debt fund, held for more than three years, are taxed at the rate of 20 percent post indexation. Otherwise they are taxed in line with the slab rate.

Skip the Canara Robeco NFO as it is a new fund in this category, but there are plenty of existing funds that come with a good track record that you can pick.

For a list of Banking & PSU Debt funds that you should invest in, pick schemes from MC30, Moneycontrol’s curated basket of mutual fund schemes.