How to select the right fixed income scheme

Fixed income schemes floated by a mutual fund invest in a portfolio of coupon bearing bonds of varying maturities and credit quality. The combined yield of the bonds gives the portfolio yield of the scheme. The bonds that the scheme holds are tradable and can appreciate in price, in favourable circumstances. Investors in debt schemes earn not only the portfolio yield but could potentially benefit from the price appreciation of the underlying bonds—due to lowering of level of interest rates in general, upgrades in credit ratings of the bonds, reduction in credit spreads and many other factors.

There have been many periods of reducing interest rates where bond portfolios have generated double-digit returns, year after year, much higher than what the portfolio yields would have initially suggested. To take an extreme example, we assume you invested in an income fund with a portfolio yield of 8%, and duration of 10 years. If interest rates came down by 2% over the next year, the annual returns for you would be closer to 28% per annum, rather than the 8% portfolio yield. Your income fund benefited from the price appreciation of bonds, over and above the interest income of the portfolio. Hence, choosing a fund based on portfolio yield alone could prove to be a costly mistake.

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The converse could also be true. A portfolio with higher yield could generate low returns due to adverse interest rate movements, credit downgrades or defaults or any other factor. There have been numerous examples in the past wherein investors have bought credit-oriented funds looking at the higher portfolio yield and later suffered as the bonds in portfolios defaulted or downgraded, resulting in a fall in the price of the bonds, thereby significantly reducing returns. Along with the portfolio yields, one must examine factors such as interest rate sensitivity, credit quality and proportion of illiquid bonds in the scheme, which could adversely affect the overall returns.

While a general mantra for fixed income scheme selection cannot be easily prescribed, it has been observed that interest rates tend to move with inflationary expectations. When economic activity is likely to pick up, excess demand for goods can raise the general level of prices.

It is time to reduce the overall maturity of your fixed income funds, as bonds tend to underperform in such circumstances in general. Conversely, when one anticipates a fall in inflation due to an economic slowdown, bond funds with longer maturity tend to outperform, as central banks try to reduce rates and bond prices appreciate.

Whenever there is a change in economic expectations, portfolio yields, on a standalone basis, are not good indicators of the future performance of bond funds. Other factors such as credit quality, portfolio duration and broad expectations about economy come into play and need to be considered to fully benefit from the potential of the bond funds.

When we analyse the performance of various debt scheme categories for the past three years and compare them to what portfolio yields of the respective categories would have suggested, the point becomes quite clear (see chart).

Fixed income funds can deliver superior returns over time. Like all investments, one needs to be judicious in selecting the right fund category suitable for the overall economic environment.

Sandeep Bagla is chief executive officer, TRUST Mutual Fund.