Investing in mutual funds comes with a common disclaimer of “past performance of the mutual funds is not necessarily indicative of future performance“. Equity fund’s performance is quite dynamic, depending on the underlying stock performance, and overall how well the fund manager manages the portfolio rotation. That does not completely dissuade investors from still viewing and filtering fund pickings based on their typical past 1-year, 3-year, or 5-year returns. After all, that’s the best starting point one would imagine to build conviction in an equity fund.
Debt funds in contrast need a completely different view for analysis. If you are simply sorting a fund based on returns and going after the top ones, you would be in for a surprise!
Debt instruments, as popularly known, are tied to interest rate movements. When you are purchasing a debt instrument, be it directly such as government securities, or indirectly via debt mutual funds, you are getting your purchase locked to a specific interest rate for which that particular investment piece is set. The duration of various investments varies, from short-term to long-term. The longer the duration, the tighter the time lock-in to the interest rate, and the more price fluctuation to your security when current interest varies. Why so? Say you have purchased your investment at a 5% return (also called the coupon rate). If the interest repo rate increases to 7%, why would someone want to trade the same instrument from you, instead of going after a similar investment currently promising a higher rate of returns? Essentially, you lose your selling power.
Instead, a more simplistic way is to keep a view of the repo rates. Repo rates are cyclic, and the governing institution (RBI, in the case of India) keeps managing them based on various macroeconomic factors (inflation being one of them). For US markets similarly, you would hear about the Fed rates being reviewed at regular intervals.
So when exactly to buy or sell? There isn’t of course a way to always predict the rate movements, but historical data will spring some numbers in front of us. Here is a 10-year bond yield chart showing the variance of the rates. There are near-term fluctuations, but when you take a zoomed-out view, you will find long cyclical moves.
Now let’s bring in the rolling returns of some debt funds, and see the correlation. I refer to this website for getting this rolling window view https://www.mfonline.co.in/mutual-funds-research/rolling-returns
I took a 3-year rolling return window of a fund that has underlying securities with long-term maturity. Let’s say we pick the time when bond yield was at its lowest, around 2020. If you had invested around that time, check the Jan 2020 – Jan 2023 three-year window returns. Close to zero, or in fact negative! In reverse, buying at peak rates, such as in 2018, would have given you upwards of 9-10% solid returns.
Long-term maturity bonds are more volatile to rate movements due to the underlying coupon interest rate lock-in. Then you have Dynamic bonds which are more flexible and may not be that extremely volatile, though they would still continue to tie to interest rate movements.
Finally, the other extreme of the debt spectrum is the Low and Ultra-Short term funds, which have very short-duration maturity instruments. They wouldn’t give peak returns like the Long Term funds, but they would have much lesser volatility.
By now, you would have got the obvious narrative i.e. instead of chasing past returns in Debt Funds, follow interest rate cycles. Timing the entry in Debt Funds is even more important, since you typically have the intent to lock in your money for a thought-out duration of time, and the opportunity lost in terms of time would be huge by one blind decision.
Debt Funds have historically outperformed Fixed Deposits, especially with a higher magnitude if you could time the interest cycles. However, they do come with uncertainty and volatility which you need to factor in as part of your risk appetite.
