Investing in fixed income mutual fund schemes can be extremely beneficial for investors. But like all good things, better results require careful consideration and a little research. No single variable, such as portfolio yield, is a reliable indicator of a bond fund’s potential return. Other factors such as credit quality and tenure of the fixed income scheme, along with an assessment of the macroeconomic scenario, can deliver good returns, while avoiding any associated risks.
Fixed income schemes launched by mutual funds invest in a portfolio of bonds with coupons of varying maturity and credit quality. The combined yield of the bond gives the portfolio return of the scheme. The bonds in this scheme are tradable and can appreciate in price under favorable conditions. Investors in debt schemes not only earn a portfolio return, but can potentially benefit from an increase in the price of the underlying bond – normally by lowering interest rates levels, upgrading the credit rating of bonds, reducing credit spreads. And because of many other factors. .
There have been several rounds of lowering interest rates where bond portfolios have delivered double-digit returns year over year, much higher than portfolio yields. To take an extreme example, let us assume that you have invested in an income fund with a portfolio yield of 8% and a tenor of 10 years. If interest rates drop 2% over the next year, your annual return would be closer to 28% per annum, rather than an 8% portfolio return. Your income fund benefited from the appreciation of the bonds in addition to the interest income of the portfolio. Hence, choosing a fund on the basis of portfolio yield alone can prove to be a costly mistake.
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Conversation can also be true. A portfolio with high returns may generate lower returns due to unfavorable interest rate fluctuations, credit downgrades or defaults, or any other factor. There have been instances in the past in which investors have purchased credit-oriented funds in view of high portfolio returns and subsequently suffered in the form of defaults or downgrades in the form of bonds in the portfolio, resulting in a drop in the bond price, Due to which the returns have come down significantly. Along with portfolio returns, one must examine factors such as interest rate sensitivity, credit quality and the proportion of illiquid bonds in the scheme, which can adversely affect overall returns.
While a general mantra for fixed income scheme selection cannot be determined easily, it has been observed that interest rates tend to move with inflationary expectations. When economic activity is expected to pick up, greater demand for goods can raise the general level of prices.
This is the time to reduce the overall maturity of your fixed income fund, as bonds generally underperform under such circumstances. Conversely, bond funds with longer maturities tend to perform better when one anticipates a fall in inflation due to an economic downturn, as central banks try to lower rates and bond prices rise.
Whenever there is a change in economic expectations, portfolio returns, on a standalone basis, are not a good indicator of the future performance of bond funds. Other factors such as credit quality, the duration of the portfolio and broader expectations about the economy come into play and need to be considered in order to fully benefit from a bond fund’s potential.
When we analyze the performance of various debt scheme categories for the last three years and compare them with the portfolio returns of the respective categories, the point becomes quite clear (See the list)
Fixed Income Funds can give better returns over time. Like all investments, one needs to be prudent in selecting the appropriate fund category for the overall economic environment.
The CEO of Sandeep Bagla Trust Mutual Fund is.
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