Long Duration Bond: Should You Buy Now?

In the world of investment, finding the right opportunity at the right time is often the key to success. One such strategy that is gaining traction is investing in long duration bond Debt Funds through systematic investment plan (SIP). This approach is in anticipation of a potential volatility in bond yields, but it’s not without its share of challenges. The article highlights the various factors associated with long duration bond investing.[EasyDNNnews:PaidContentStart]


Not long ago in the years 2019 and 2020, a few categories of debt funds generated returns in double digits. For example, ICICI Prudential Long Term Bond Fund from the long duration category generated return of 11.58 per cent after generating return of 12.75 per cent return in 2019. There are other categories also such as gilt with 10-year constant duration that saw a double-digit return in the same period. For example, funds such as, Bandhan Government Securities Fund – Constant Maturity Plan – Direct Plan from this category saw a return in double-digits for 2019 and 2020. 

One of the reasons for such returns was the sharp fall in yield in these two years. For example, in 2019 the benchmark 10-year Government of India bond yields dropped by 11 per cent. The 10-year GOI bond yields were trading at 7.385 per cent at the start of 2019, which dropped to 6.532 per cent by the end of 2019. Similarly, in 2020, the 10-year GOI bond yields dropped by 10 per cent and were at 5.887 per cent at the end of 2020. 

There is an inverse relation between bond yields and bond prices and hence the performance of bond funds. 

This is the reason why debt funds dedicated to investment in long term bonds have yielded anaemic returns in the last two years. In 2021, when bond yields witnessed a 9 per cent increase, long duration bond funds such as Bandhan Government Securities – Constant Maturity Regular Growth and ICICI Prudential Long Term Bond Growth experienced more modest returns of 2 per cent and 3 per cent, respectively. Conversely, in 2022, as bond yields surged by 13 per cent, the returns from these funds declined, with Bandhan Government Securities – Constant Maturity Regular Growth yielding 1 per cent and ICICI Prudential Long Term Bond Growth producing 2 per cent. This inverse correlation highlights the sensitivity of long duration bond funds to changes in bond yields, where rising yields tend to suppress returns, and falling yields can bolster fund performance. 

Falling Yields in Coming Quarters

The latest macroeconomic numbers and certain developments points towards a fall in bond yields going ahead. First is the CPI inflation moderated from 6.83 per cent YoY in August 2023 to 5.02 per cent in September 2023, primarily driven by a dip in vegetable prices and the ripple effect of the LPG price cut. While market participants expected a deceleration towards 5.50 per cent, the actual print surprised significantly on the downside. The inflation has now come back to the Reserve Bank of India’s comfort level of below 6 per cent after a gap of two months.  

Core inflation (CPI excluding food and beverages, fuel and light), which averaged 6.1 per cent in FY23, has moderated in the recent months and eased further to 4.8 per cent, also due to base effect. Rainfall picked up in September after a very weak spell in August, and ended the season 6 per cent below the long period average. The current kharif crop sowing for rice is slightly higher than last year, but very weak rainfall since August could impact the final harvest and crop quality. The government has been taking various supply side measures which will impact the inflation. Falling inflation may lead to lower interest rates and bond yields. 


 

Another important factor that will help the moderation in bond yields is the announcement by JP Morgan that India will be included in its Emerging Market Global Index starting June 28, 2024. India’s weight in the index will rise to 10 per cent by March 31, 2025. Additionally, India will also be included in other smaller indices run by JP Morgan such as the JADE Global Diversified Index. Accounting for active money flows that may want to position ahead of the actual index inclusion, the market expects USD 25–30 billion of flows into the local bond market over this timeframe.  

An additional consideration is whether other indices outside of JP Morgan may now be more favourably inclined to include India’s bonds. If this were to happen then the size of flow may potentially turn out to be even larger over the next year and a half. Tenor-wise data shows that securities in the range of 5-10 years are likely to get the maximum benefit in terms of the outstanding amount. Hence, we may witness a downward shift of the entire yield curve in this segment. 

If we look at the movement of India’s yield curve post the announcement of India’s inclusion in the global bond index, it is interesting to see that the 5–7-year part of the curve noticed a drop in yield between 1-4 bps. For the benchmark 10-year paper, the initial drop in yield post the announcement already has undergone a correction. However, post FY25, depending on flows, a downward bias towards the 7 per cent range seems feasible. Therefore, going ahead we may see yields dropping in the next couple of years, which may help investors to earn returns in double digits.  

Nevertheless, we may see some short-term blips chiefly from US’ yields. The potential open market operations announced by RBI have now introduced a local risk. Given that this was unanticipated and remains uncertain in contours, the reaction for the time being has been large from market participants. However, the underlying framework broadly remains the same. It is expected that eventually the local trigger will likely count as a small blip. US’ bond yields are a more persistent variable to monitor in the near term. Hence, we suggest that investors should go ahead and start SIP in long duration bond funds.
 

New Taxation Rules of Long-Term Debt Funds 

The removal of the indexation benefit on debt funds is bad news for investors. As an investor, what do you recall about the Finance Act 2023 or the Union Budget? The amendment in the Finance Bill 2023 which took away the indexation benefit from debt funds was indeed a body blow for investors. The removal of the indexation benefit on debt funds from the Finance Act 2023 is unfavourable for investors, removing a previous tax advantage. The Union Budget 2023 introduced changes that affect various mutual fund types. 

This includes debt, gold, hybrid, international equity and funds of funds. These changes mean that these funds will now be subject to taxation at applicable slab rates, which may lead to an increased tax burden for investors. The revised tax rules, effective from April 1, 2023, classify debt funds with 35 per cent or less investment in equity shares as short-term capital gains, aligning them with the Income Tax slab of individual investors. This change aims to create a consistent tax policy across debt instruments and eliminate tax arbitrage. 

Riding the Wave 

In the world of investment, finding the right opportunity at the right time is often the key to success. One such strategy that is gaining traction is investing in long duration bond debt funds through systematic investment plan (SIP). This approach is in anticipation of a potential volatility in bond yields, but it’s not without its share of challenges. 

The SIP Advantage

Systematic investment plans, commonly known as SIPs, have long been the preferred choice for those looking to invest in mutual funds, particularly equity funds. However, as market dynamics change, so do investment strategies. Long duration bond debt funds, which typically carry a higher risk-reward profile, have started to attract investors’ attention. So, what is the reason? The potential for a drop in bond yields in the medium term, will remain volatile in the short term. One significant factor that can create turbulence in the bond market is the trajectory of US’ inflation and its effect on US’ bond yields. When US inflation rises and US’ bond yields follow suit, it often has a ripple effect on bond yields in India. 

As a result, investors in long duration bond debt funds may experience some unexpected spikes in yields during their investment journey. Investing in long duration bond debt funds or debt funds with duration greater than seven years through SIP provides a structured and disciplined approach that helps investors navigate the market’s fluctuations. The inherent benefit of SIP is its ability to average out the cost of acquisition. During periods of rising yields, SIP investors can buy more units at lower NAVs, capitalising on the market’s volatility 

This approach can potentially help offset the impact of sudden yield spikes, allowing investors to accumulate more units when the yields are high. Investing in debt funds with higher ‘durations’ through SIP can be a strategic move, especially if you believe that bond yields are likely to drop. However, it’s vital to stay informed about the dynamic nature of the bond market and the potential impact of global factors, such as US inflation and bond yields. With a well-structured SIP approach and a diversified portfolio, investors can better position themselves to weather the bond yield storm and harness the rewards of long-term bond investments. 

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