Long-term debt funds could deliver up to 15% in the next one year if rate cuts happen as expected.

 

Though equity is expected to generate better returns in the long term, most experts think that debt is a good bet in the short term. Due to the potential to generate capital gains, bonds are a good place to be in India now. This is because the interest rates are expected to come down in the coming months. The RBI may cut rates on or before the September policy review. Further rate cuts could happen in the next calendar year. We expect the 10-year government bond yield to fall to around 7.25-7.35% by March 2016 from the current 7.78%. The 10 year yield has already came down from 8.56% in the past one year (see chart).

The heightened risk in equity due to a possible FII outflow is another factor that is making experts bullish on debt now. Equity markets are at more at risk of correction than fixed income markets because foreign ownership is quite high for Indian equities as compared to bonds (less than 2% of outstanding issuances).

Since long-term bonds are more sensitive to interest rate fluctuations, investors should use the long duration funds to invest. If interest rates fall as expected, these long duration debt funds are likely to generate good returns of around 15% in the next one year (8% yield and another 7% from capital appreciation). However, longterm bonds are more volatile. If you are looking for stable returns, go for short-term bond funds. These schemes may not give very high returns because their potential to earn capital gains is limited by the shortterm bonds in their portfolio. However, they will still churn out 9% annualised returns in the next 1-2 years. Long duration debt looks better on the risk-reward basis.If debt investments are capable of generating 15% returns in one year, I need much higher return from equities. That appears unlikely in the current scenario