Income funds or bond funds have given you returns of between six to ten per cent per annum compounded, over a five-year period. The one year returns have been betwe-en six and eight per cent and the three year retu-rns have been between eight and eleven per cent.
Of course, this is at a point in time (data as on August 30) and different time points would give you differing return matrices. For instance, the last one month returns have been 12 and 18 per cent (annualised). There are times of negative returns. So income funds are not guaranteed to give us either regular income or steady growth. These funds are as much subjected to market forces as any other class of asset. In case of income funds, the primary driver is the interest rate movements.
As interest rates go higher, it is logical to think that the returns on these also should be higher. Unfortunately, what happens is the opposite. The assets that these funds own already carry a fixed rate of return. When interest rates go up, these assets fall in value, leading to a dip in Net Assets Value. The opposite is true when interest rates fall.
Income funds are good vehicles for those who like to time the markets and would like to capture an environment of falling interest rates. For those who are willing to take slightly higher risks, the corporate bonds offer a more direct opportunity. In a world full of ever changing daily turmoil, it is unlikely that we would ever have a steady state of things for any length in time. Hence, each asset class has its place in time and opportunities differ.
We may see one more interest rate hike by the RBI and that should be the last one, for a couple of years. Interest rates have reached a level that makes money so expensive that it would hurt demand. There is a fear that more hikes will also curtail new supply creation. RBI, however, thinks that by raising interest rates, it will bring down inflation.
Post-September, in 12 months or so, we should see a softening of interest rates. In one year from now, we could see interest rates lower by one to 1.5 per cent per annum. This would translate into a capital appreciation of between three to five per cent on a debt paper, depending on its maturity period.
To this add a return of around 10 per cent per annum on existing assets in an income fund the total return in a year could be around 15 per cent or so. The key to successful execution of this strategy would be to exit when the total return reaches this level.
If you share the belief that interest rates will start to come off from here, it is a good time to get in to income funds and stay put till the interest rates fall off.
Of course, my assumptions are based on a premise that the RBI will start to bring down interest rates from early 2012. For those with a little more appetite for risk, it is best to buy the bonds directly from the secondary markets. One can pick up five or 10-year double A rated paper at yields of 11 per cent per annum or higher.
The writer is an independent investment analyst.