Should investors move from long-term to short-term debt funds after RBI's rate cut?

Mumbai: Investors, who made strong gains from long-term debt funds over the past year can consider booking profits and shift to shorter-term bond funds, say fund managers. With the Reserve Bank of India (RBI) expected to pause rate cuts for now after a surprise 50-basis-point cut in interest rate on Friday, fund managers and investment advisors said the best of the rally in longer-duration bonds may be over.

“Fixed income returns hereon will be dominated by accruals rather than capital gains because after the rate cut of 50 basis points, there is limited room available for further cuts,” says Manish Banthia, chief investment officer, fixed income, ICICI Prudential Mutual Fund. He recommends investors to opt for debt categories like low duration, ultra short duration and the money market category.

Bond prices and interest rates move in opposite directions. When interest rates fall, bond prices rise, generating capital gains for investors in long-duration debt funds. The recent rise in bond prices (and fall in bond yields), ahead of the 50-basis point rate cut by the RBI, triggered such gains. But with few interest rate cuts in the anvil with the RBI governor Sanjay Malhotra commenting that the monetary policy is left with ‘very limited space’ to support growth, fund managers say the scope for further price appreciation in bonds is limited.

This is why fund managers, like Banthia, say returns from debt funds will likely come from accruals–the regular interest earned on bonds-rather than from bond prices rising further.

“After the rally in long-duration bonds, where investors earned a capital appreciation, it is time to take profits and move to accrual funds that offer better risk reward,” says Prateek Sinha, founder, Deep MFD, a mutual fund distributor.

Sinha suggests investors could buy floating rate funds, that invest in debt securities with interest rates that adjust periodically based on a benchmark, such as the RBI repo rate.In last one year, yields on the 10-year benchmark government bonds, which are part of long-term bond fund portfolios, have fallen from 7.01% to 6.23%, a gain of 78 basis points, which resulted in significant capital gains for fixed income investors in long duration funds . As rates were cut, bond prices rose giving investors a capital appreciation. This helped investors earn an average return of 11.65% on their long tenure gilt funds, which invest in government securities, as per data from Value Research.Investors in bond mutual funds must lower their return expectations given the limited room for interest rate cuts.