Why Debt funds returns will Improve Soon?

The last 2 years have not been good for debt fund investors. Returns of almost all debt fund categories (except one) have been low. But this will change, pretty soon.

Debt funds will very soon start giving good returns.

Here is the return profile of different debt fund categories in last 2 years, i.e. 2021 and 2022 and loosely compared with previous few years:

As you can see, last 2 years haven’t been good. More so when you see the good returns provided by many debt categories in years from 2017 to 2020.

So what makes me think that the debt funds will start giving good returns very soon.

As you already know, inflation has been rising. Not just in India but in other mature economies as well. So to tackle this rising inflation and to not let it get out of hand, RBI has been steadily increasing repo rates over the last few months.

Now when these repo rates or the interest rate in the economy rise, the bond prices start falling. And this is simply because bond prices and the interest rates are inversely related. If interest rates fall, bond prices will rise. If interest rates fall, bond prices will rise.

So with the increase in rates and the fall in bond prices, the debt funds holding these bonds are also impacted. The NAVs of these debt funds holding bonds (whose prices are falling) are also falling.

And when the debt fund NAVs fall, its obvious that the returns shown (past returns over last 1-2 years) start looking bad as of today.

Now have a look at the debt fund returns table above again.

The debt fund returns are down in last 2 years because of this reason alone.

So why will things improve now?

When interest rates are hiked (as is happening now), there is a positive impact as well. The effect is not instant and may take a few months/quarters to play out. And this effect is that Yield-To-Maturity (or YTM yields) of these bonds have started increasing. And this is a clear indicator that returns from debt funds will increase very soon.

Few weeks back, my views were published in The Hindu Business Line (26 Nov 2022) in an article titled Debt fund yields turn attractive at both short- and long-ends.

The debt funds yields (YTM) have been increasing across almost all the debt funds categories in India now. So I agree that debt fund returns have been a disappointment in the last two years, we can be quite sure that the debt funds returns will increase substantially very soon.

When exactly will this happen?

RBI has been hiking repo rates aggressively but it might slow down or take a pause. So inflation, will also start cooling off due to the twin effect of high base effect and the increase in rates showing their effect. So its possible that even though we are not there yet, we might be getting closer to the peak interest rates. So as inflation slows down (or starts reversing) and RBI too decides to end the rate hike cycle, the debt fund returns will start improving.

I know all this sounds like trying to predict debt fund returns. But this is what the data is pointing at. Hence, I am explaining it here.

And with banks increasing FD rates, you too might be thinking about going to FD when debt fund returns haven’t been great.

But don’t make the mistake of comparing future FD interest rates (you get now) with the past debt fund returns. You might miss out on good returns that are to come from debt funds in near future.

I am not saying FDs are bad. They are indeed getting quite attractive with increase in FD rates. And if you are a conservative saver, then please put money in fixed deposits in safe banks. But if you are a moderately aggressive investor, then it might be a good idea to start getting into debt funds (or remain there if you are already invested) given the impact of increasing YTM yields set to play out very soon.

Also, don’t forget about the indexation benefit in debt fund taxation which makes debt funds much better in post-tax returns if you remain invested for 3 or more years.

And which debt funds are best in given scenario? Stick with debt funds that have comparatively shorter average portfolio maturity duration.

So that was why there is a high possibility that debt funds will give good returns in 2023 onwards. Not a prediction but an analysis based on current data and few assumptions. Fingers crossed. If you have doubts or are confused, please talk to your investment advisor to help you.