Income accrual, dynamic bond funds turn attractive

They would benefit from rate cut and likely credit easing

The policy changes by the central bank directly impacts your investment in debt funds. According to Akhil Mittal, a senior fund manager with Tata Mutual Fund, income and gilt funds would make the best capital gains after the rate cut. Yields across the curve fell 10-15 basis point (bps) and existing investors have gained to that extent in a day.

To benefit from the rate cut, experts suggest investors  look at short-duration funds if they have an investment horizon of less than a year. For longer tenure, up to three years, they should opt for medium-term income accrual or bonds funds.

Vidya Bala, head of mutual fund research at FundsIndia.com, says the portfolio of dynamic bond funds are well positioned to further benefit from the rate cut. They keep a good mix of gilt and bonds for this. The former component can give investors returns arising out of the rate cut. Bonds will gain over the next 18 months as the credit cycle eases.

Income accrual funds bet on corporate bonds, which benefit when there is credit easing. These funds already hold corporate papers that have higher maturities than the ones that would be issued after the rate cut. The difference between the interest rates will result in capital appreciation as most of them will hold it until maturity.

With credit easing, there are also chances that the companies’ rating will be upgraded that would further cause a rally in bonds. In the past few months, DHFL was upgraded from AA+ to AAA, Mahindra & Mahindra Finance was upgraded from AA+ to AAA. Even smaller firms with a sound balance sheet have witnessed it, such as Sundaram BNP Paribas Home Finance (AA to AA+) and Ashok Leyland (A+ to AA-).

“Investors should ideally keep an investment horizon at par with the portfolio maturity of the fund. Dynamic bond fund and income accrual schemes have an average maturity of two and a half to three years,” says Bala. Due to taxation, it is also better to stick with medium-term income funds for three years. If a person holds debt investment for less than three years, he or she will need to pay short-term capital gains tax. For holding period above that, there’s benefit of indexation.

One can stick to short-term funds, such as liquid and liquid-plus schemes, if one’s investment horizon is less than a year. Nilesh Shah, managing director at Kotak Mahindra Asset Management Company, feels short-term funds will give good returns once inflation comes down.

Experts say investors need not tinker with their debt portfolio as shifting won’t be tax-efficient. If they do shift, say from a short-duration fund to a medium-term one, and the yields are affected due to some event, they will suffer a loss.