Time to bond with 5-year income funds

The Reserve Bank of India's credit policy announcement last Thursday took the debt market fraternity by surprise. Bond traders were not expecting the RBI to tinker around with any of the rates in the system. But, the central bank thought otherwise.

The reverse repos rate (the rate which banks earn from the central bank when they park surplus funds with the latter) was hiked by 25 basis points from 4.75 per cent to 5 per cent.

Not surprisingly, bonds prices fell. Looking back, over the past year or so, the yield on the 10-year benchmark bond has moved up by about 200 basis points from about 5 per cent in April last year to around 7.25 per cent, at present.

And the yield on the five-year bond, which even till the end of March was at 6.3 per cent, is now almost 7 per cent.

Till now most income fund managers have been chary of recommending investments in schemes other than floaters and liquids because they were not too sure how high interest rates would climb, given inflation pressures from soaring oil and commodity prices.

Bonds, they believed, were not fully priced for negatives such as inflation. However, with the recent moves, fund managers believe that though the coast may not be completely clear, given that the government continues to borrow heavily, it could be time to put in some money into income schemes, which are for a five-year tenure.

Or even look at schemes, which have an equity component, where the upside could be bigger.

Says Mahendra Jajoo, VP, fixed income, ABN Amro AMC, "Given the current outlook for inflation of between 5 per cent and 5.5 per cent and the fact that the 10-year benchmark has moved 200 basis points, the comfort level for entering into the bond markets has improved. Interest rates may still move up, but a small allocation to debt should not pose too much of a risk."

Adds K Ramanathan, fund manager, fixed income, Birla Sunlife AMC, "The spread between the repo rate and the five-year bond is now 200 basis points and the current yields are pricing in a repos rate of 6 per cent, with a neutral to marginally upward stance. The only reason why market is not rallying is because of the government borrowing and the paper is selling at higher yields. The markets could be volatile, so there is some element of risk, but this could be a good time to enter with a medium term investment horizon."

Samir Kulkarni, senior VP, fixed income, Franklin Templeton, believes that "it might be a good time to move some money out of liquids and floaters and put into longer term schemes.

"Even a closed-ended scheme can make sense because the investor can redeem his units, by paying an exit load if he needs to do so urgently," he explains.

According to Dhawal Dalal, VP, fixed income, DSP Merrill Lynch," It's difficult to tell whether an investment in an income scheme for five years would return more than the RBI Bond in the current situation, but intuitively I would think an income scheme might return more, given the trading opportunities and the indexation benefits."

Indexation benefits (where the capital gains tax) is calculated on the final redemption value minus the indexed cost of acquisition, makes returns more attractive, especially if held for a longer period.

When indexation benefits are availed of by the investor, the long term capital gains tax, 10 per cent in this case, doubles to 20 per cent.

According to Jajoo, there are schemes that allow the fund manger flexibility while investing. Since the fund manager is not committed to any single tenure paper or paper from any single category such as gilts or corporate bonds, he has the option to switch to alternative tenures if the situation so warrants and can try to better the returns.

Instead of opting for a pure income scheme, one could also start taking a look at a hybrid fund -- one that invests in both debt and equities.

Even if equities form the smaller portion of the corpus, the returns would normally be far higher and so would bolster the overall returns for the scheme.

For instance, Templeton has launched a five-year, closed-ended scheme, which would put 70 per cent of the corpus in fixed income products with the remaining being in equities.

One must keep in mind the expense ratio of 150 basis points that would be built into the returns.

Kulkarni, however, observes that even after accounting for the expenses, a return of around 6-7 per cent on the 70 per cent debt component and a 14-15 per cent return on the equity component last, should result in a handsome return, once again because of the indexation benefits, that would be available five times in five years.

DSP Merrill Lynch too has schemes that allows investors to choose varying levels of the equity component -- from up to 10, 20, to 30 per cent -- the balance being put into debt paper such as corporate paper, floating rate bonds and money market instruments.

Says Dalal, "Equities tend to perform well over a longer term, so a balanced fund with prudent debt and equity allocations, should ideally do well."

Blend your investments -- that appears to be the general consensus at this point in time. Buy a bit of both, equities and debt, but with the clear intention of holding on to the investment for at least three to four years.