Debt mutual funds delivered sharply higher returns of 14-18% in the last year due to declining yields on long term debt instruments. However, more recently the weakening rupee has caused NAVs of gilt and income funds to fall, resulting in some negative returns. Going forward, returns are likely to be more subdued as interest rates are unlikely to decline much further in the near term. Investors should scale back expectations to 8.5-10% annual returns from debt funds. Short term income funds may perform better over the next few months compared to gilt and income funds due to their shorter duration exposure.

1. Retail Research 1
Debt Mutual Funds – Is the time of super returns over for the time being? July 13, 2013
Debt mutual funds delivered sharply higher returns close to 14-18% (absolute returns) in the last one year period all thanks to the sharp
decline in the yields of long term debt instruments. The bond markets witnessed a significant rally between Mar 13 and May 13 on the
back of rate cuts and rate cut hopes, with the yields of 10 Year G sec benchmark fallen to 45 month low of 7.11% on May 23, 2013.
However, later weakening of the rupee against the dollar resulted in the NAVs of Gilt and Income funds falling, with the result that these
funds posted negative returns close to 1-2% in the last one month period.
Performance of Debt Categories:
Category 3 Month 6 Month 1 Year 2 Year 3 Year
03 Apr 2012
To 24 May
2013 Absolute
03 Apr 2012
To 09 Jul 2013
Absolute
Standard
Deviation
Dynamic Income Funds 2.51 4.54 10.48 9.85 8.69 14.52 13.31 0.11
Gilt Funds - Medium & Long Term 3.76 5.63 11.94 10.58 8.51 17.14 15.79 0.16
Gilt Funds - Short term 2.59 4.85 9.83 9.16 7.80 13.45 13.10 0.11
Income Funds - All 2.40 4.42 10.30 9.98 8.68 14.34 13.43 0.11
Short Term Income Funds 2.15 4.34 9.39 9.39 8.49 11.89 12.27 0.05
Note: NAV values as on 9th
July 2013.
We have chosen the dates for the following reasons. During April 03, 2012, the yields of 10 Yr G sec benchmark witnessed its last peak
of close to 8.74% given in the last 18 months period. On May 23, 2013, the yields of 10 Year G sec benchmark saw a 45 month low of
7.11%. July 09, 2013 is the latest date that we have chosen for our study wherein the yields of 10 Year benchmark was at 7.55%.
The above table portrays that Gilt funds generated close to 17% absolute returns while the Income and Dynamic Income funds posted
close to 14% returns during the bond market rally that witnessed between April 2012 and May 2013. However these gains were cut if
the period of analysis is extended to July 09, 2013 (due to the weakness in the rupee value against the dollar and the resultant sell-off
in bond markets).
For similar large returns to recur the interest rates have to slide further from here. But it seems difficult in the near term. The returns
from the gilts and Income funds are likely to be subdued due to the hardening bond yields following the rupee weakness. If the rupee
starts to appreciate then the 10 Year G sec yields could fall gradually. However, there may not be a repeat of FY13 kind of returns.
Investors could do well to scale back their expectations of returns to the 2 and 3 year returns of 8.5-10% p.a. from now on.
Risks of gradual rise in G sec yields remain going forward. The probability of low or negative returns in gilt and income fund in some
months is also possible - may be till next general elections. So investors should not look into the past performance while investing in
long term debt mutual funds. The performance of the debt funds would be purely based on the movement in the interest rates. The
market gain can disappear if the rates begin to increase.
In general, Fund managers get returns from
1) Trading in instruments to ride on expected volatility which is more prevalent when yields are trading in a band and
2) Persistent fall in yields that lead to MTM gains.
In the next few quarters it seems that trading profits could get offset by MTM losses due to intermittent rise in yields leading to subdued
performance by Debt Mutual funds.
Liquid, Ultra Short Term and Short Term Income funds (and to some extent Dynamic Income funds) could be the preferred choice over
the next few months given the fact that liquidity condition in the banking system is seen improving in the last few days on the back of
government spending and is expected to be easy going forward on the back of credit growth being slower than deposit growth in the
banking channel.
Credit growth being slower than deposit growth in the banking channel:
11
14
17
20
23
26
Jul-10
Sep-10
Nov-10
Jan-11
Mar-11
May-11
Jul-11
Sep-11
Nov-11
Jan-12
Mar-12
May-12
Jul-12
Sep-12
Nov-12
Jan-13
Mar-13
May-13
Deposit Grow th Credit Grow th

2. Retail Research 2
All eyes are on plunging of Rupee against the dollar. The rupee hit all-time low of 61.21 on 7th July 2013. The returns from the gilts and
Income funds are likely to be subdued due to the hardening bond yields following the rupee plunge.
If the rupee starts to appreciate then the 10 Year G sec yields could fall gradually. At present, the 10-year G-sec yield is hovering in the
range of 7.5% level. Given the moderation in the inflation, even though the RBI is willing to shift its stance from anti inflation to pro
growth, further rate cut is unlikely in the near term as the rupee could take time to rise sustainably against the dollar. Dollar has been
strongest among major currencies at this point of time (as reflected by the Dollar index) as the US economy is showing signs of steady
growth hence the strength in the USD is likely to continue.
From the above, one can assume that the RBI is unlikely to cut policy rates by more than only 25 to 50 bps in 2013-14 and that too
earliest in Q3FY14 and the central bank to maintain status quo in the forthcoming policy meeting scheduled in July 30, 2013.
Conclusion:
Hence, short term income funds that are managed with 2-3 years Average Maturity may be the right bet in the current scenario for any
kind of investors while the investors who wish to stay investing for more than 18 months or two years or more can consider Income
funds, Dynamic Income funds and Gilt funds (although with reduced expectations). Selective Dynamic funds which are managed
actively can be suitable for medium risk appetite investors for medium term say for one year period as these funds are flexible to
manage duration and choose between corporate and government bonds. Investors those who do not want MTM risk can choose Ultra
Short term funds as they are low risk low return products.
10 Year G sec yields Vs. WPI Inflation & Repo Rate: Clear correlation seen among these three
-2
0
2
4
6
8
10
12
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
5
6
6
7
7
8
8
9
9
10WP I R epo R ate 10 Y (R H S)
USD/INR Vs. 10 Year Gsec Yield:
40
45
50
55
60
65
Jul-09
Sep-09
Nov-09
Jan-10
Mar-10
May-10
Jul-10
Sep-10
Nov-10
Jan-11
Mar-11
May-11
Jul-11
Sep-11
Nov-11
Jan-12
Mar-12
May-12
Jul-12
Sep-12
Nov-12
Jan-13
Mar-13
May-13
Jul-13
USD/INR
6.0
6.5
7.0
7.5
8.0
8.5
9.0
10YrGsecyields
USD/INR 10 Year G SecYields (RHS)
Average Maturity:
The Average maturity chart below reveals that despite persistent moderation seen in WPI, the debt mutual funds cut their Average
Maturity in March 2013 due to profit booking. Investors booked their MTM gains from debt categories across the board given the
skepticism/doubt over the fall of G sec yields below 7.50% range. However, Mutual Funds increased their portfolio duration during April

3. Retail Research 3
2013 and cut again in May month as the inflation numbers remained stubborn. Weakness in Rupee against the dollar also weighed on
the market sentiments.
Average Maturity (monthly) of Debt fund categories:
0
20
40
60
80
100
120
140
160
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Gilt - LT Short Term Income Income - All Dynamic Income
Corporate Spread:
The below chart shows that the fall in spread of AAA corporate bonds vs. Gilts in December 2012 led to MTM gains for debt mutual
funds. Between December 12 and March 13, as the spread started to rise, the mutual funds increased their exposure to the corporate
papers, but with reduced duration.
Playing on Corporate Spreads: AAA corporate bonds vs. Gilts
50
70
90
110
130
150
170
190
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Dec-12
Jan-13
Mar-13
Apr-13
May-13
Jun-13
7
8
91 Year AAA 5 Year AAA
10 Year AAA 10 Y Yield (%) (RHS)
Allocation into Government securities by debt categories over periods:
0
10
20
30
40
50
60
70
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
6.5
7.0
7.5
8.0
8.5
9.0
G sec holding by Dynamic Income G sec holding by Income funds - All
G sec holding by Short Term Income 10 Yr Gsec Yield (RHS)
G sec holding rose consistently during the period from Feb 12 to Dec 12 but sharply came off in Mar 13.

4. Retail Research 4
Allocation into Corporate debts by Debt categories over periods:
30
35
40
45
50
55
60
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
7.0
7.4
7.8
8.2
8.6
9.0
Corp debt holding by Income funds - All Corp debt holding by Dynamic Income
Corp debt holding by Short Term Income 10 Yr Gsec Yield (RHS)
Among the debt categories chosen Short term income funds witnessed gradual increase in the allocation into corporate debt. As per the
latest data (May 2013) the Average Maturity of the Short term Income category was at 56 months.
Analyst: Dhuraivel Gunasekaran (dhuraivel.gunasekaran@hdfcsec.com)
RETAIL RESEARCH Fax: (022) 3075 3435
Corporate Office: HDFC Securities Limited, I Think Techno Campus, Building –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. Crompton
Greaves, Kanjurmarg (East), Mumbai 400 042 Fax: (022) 30753435 Website: www.hdfcsec.com
Disclaimer: Mutual Funds investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared
by HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made
available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is
from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to
time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or
other services for, any company mentioned in this document. This report is intended for non-Institutional Clients.