Top performing debt funds

1. Rate hikes bode well for ultra short term MFs

Short-term bonds do relatively better when rates rise, as is expected next year.

Ultra short duration funds, which include categories like Ultra Short Duration, Low Duration & Money Market funds, are ideal for risk-averse people who want to invest for a short period of time. Ultra short term funds have delivered 3.21% returns this year, and low duration funds have given 3.75%. Experts believe these funds could do marginally better now with RBI expected to increase rates next year. “If interest rates go up, it does not make sense to stay invested in longer-term funds,” says Saurabh Mittal, founder-director, Circle Wealth Advisors.

As rates/yields rise, bond prices fall. Long-term bonds are more sensitive to interest rate changes. This is because these have a greater duration than short-term bonds that have fewer coupon payments remaining.

The top fund in the category, ICICI Pru Savings Gr, with 4.4% returns, more than the category average of 3.21%, used cash holdings to tide over market volatility. “Predominantly, we had exposure to floating rate bonds and AA-rated spread assets,” says Rahul Goswami, CIO, fixed income, Fixed Income, ICICI Prudential AMC. The second fund, ICICI Pru Ultra Short Term, focussed on “having higher allocation to fundamentally robust AA-rated papers in the portfolio,” says Manish Banthia, senior fund manager, Fixed Income, ICICI Prudential AMC.

“We maintained a marginally overweight duration because we believed RBI is going to be possibly slower in reacting on monetary policy front. Also, the fund kept portfolio yield to maturity in focus. The portfolio chose to remain invested in a healthy mix of AAA and non-AAA assets,” says Anupam Joshi, fund manager, fixed income, HDFC Asset Management Company Ltd.

2. Short to medium duration: A mixed bag

After a lacklustre 2021, advisors expect some of these funds to do better in anticipation of rate hikes.

This year, short-duration funds gave category average returns of 3.99%. This category includes short duration, banking & PSU funds and medium duration funds. Banking and PSU funds returned 3.30%, while medium duration funds yielded 5.11% on an average. “Returns for debt funds have been lacklustre. Banking and PSU funds, too, haven’t performed as expected. This could continue for another year or so,” says Shweta Jain, founder of Investography, a Bengaluru-based financial planning firm.

Comparatively, however, investment advisors expect some of these funds to do better next year in anticipation that RBI will increase rates. “Since average maturity is lower in short-term funds, the impact of rate hikes, which we are expecting, will be minimal. These funds would have the flexibility to buy new papers with higher yields,” says Dinesh Rohira, founder and CEO of personal financial and wealth management platform 5nance.com.

The three winners in the category – SBI Magnum Medium Duration, ICICI Pru Medium Term Bond and ICICI Pru Short Term funds – made some smart moves to get their investors through a volatile year. “During the pandemic, we ensured the companies had enough liquidity with them, or were able to generate enough liquidity to go through any sort of stressed time period,” says Dinesh Ahuja, fund manager at SBI mutual fund.

The second winner, ICICI Pru Medium Term Bond, searched for value. “Even in the AA segment, you have to choose the right assets which are either priced well, or assets which have the opportunity to move up on the credit scale,” says Manish Banthia, senior fund manager, fixed income, ICICI Prudential AMC.

3. Medium to long duration: Risk management remains the key

Rate uncertainty hangs over category returns; rate hikes will hit returns further.

This year, returns have been moderate or muted across categories. This category includes dynamic bond, medium to long duration, long duration and gilt funds. Medium to long duration funds, which invest in debt and money market instruments that have an average maturity of four-seven years, gave category average returns of 3.22%. Meanwhile, long duration funds, which invest in fixed income instruments of longer tenures, returned 2.57%.

Corporate trainer and author Joydeep Sen says since RBI has cut rates over the last two years or so, portfolio accrual is on the lower side. He sees similar performance next year as well.

“Even though everybody knows RBI will hike rates, there is a nuance there – bond yields or interest rates and bond prices move inversely, which means when RBI hikes rates, returns will still be muted because on one hand, accrual is going up, but on the other hand, bond prices are coming down. So, the NAV (net asset value) is impacted,” he says.

The top funds in the category — ICICI Pru All Seasons Bond, SBI Magnum Income and ICICI Pru Gilt — focussed on risk management to stay ahead in the game. “The study of the behaviour of market and economic cycles–these are the two most important things I concentrate on as part of my strategy,” says Manish Banthia, senior fund manager, fixed income, ICICI Prudential AMC. “The outperformance is attributed to effective duration management. Also, the robust credit evaluation process has assisted in the right selection of investments, avoiding any sort of negative credit events in both these funds (SBI Magnum Income and SBI Magnum Medium Duration),” says SBI MF’s Dinesh Ahuja.

Next year is expected to be a difficult year for fixed income overall. Manish Banthia says while investors would want higher yields, central banks are still looking to support growth. He says investors should not expect higher returns from fixed income as base yields in most segments of the market are at historically low levels. The next year will be about managing risk. “Omicron is a near-term scare, and we’re not sure what its overall impact will be. From a market perspective now, the more important thing is to manage risk for investors, rather than look at returns,” says Banthia.

4. Corporate bond funds: In a sweet spot

Minimum 80% investment in AA+ and above bonds makes them less risky.

Corporate bond funds are best suited for investors looking for consistent returns without much volatility. These have given an average return of 3.41% in last one year. Next year, however, is expected to be better with anticipation of rate hikes. “With rising rates, we might see the performance of corporate bonds improving. Since they work more on accrual strategy, they are good for investors looking for consistent returns in the medium to long-term,” says Sebi-registered tax and investment expert Jitendra Solanki.

The top three performers in the category are Aditya BSL Corporate Bond fund, HDFC Corporate Bond fund and ICICI Pru Corporate Bond fund. Timing has been the key to their performance. “This year, 85% of the fund remained invested in one-three year corporate bonds, which is buy and hold till maturity, and the residual 15% was utilised for modulating duration depending on valuation and policy,” says Kaustubh Gupta, co-head, fixed income, Aditya Birla Sun Life MF.

HDFC Corporate Bond’s fund manager Anupam Joshi says smart positioning has helped his fund do well. “Since 2018, we had maintained higher duration in the portfolio vis a vis other MF schemes in this category. However, since 2020, owing to our view that the interest rates had bottomed out, we have been gradually reducing duration in this fund.,” he says.

The outlook for 2022 is promising. “Even if Omicron spreads, I don’t think the impact is going to last beyond three months. We should still have a good eight-nine months cycle that will enable corporate bond funds to perform better, unless other new variants create disruption,” says Dinesh Rohira, founder and CEO of personal financial and wealth management platform 5nance.com.