‘They can transition from short to long-duration funds when the yield curve normalises.’
The Monetary Policy Committee of the Reserve Bank of India chose to keep the repo rate unaltered at 6.5 per cent on June 8, 2023.
This decision, accompanied by an unchanged stance, emphasises the RBI’s commitment to reining in inflation.
Consumer inflation is expected to average 5.1 per cent in 2023-2024 financial year, higher than the target rate of 4 per cent.
Is a rate cut imminent?
Benign commodity prices and a good monsoon leading to high food production could ease inflation.
Conversely, negative developments on these fronts could cause prices to surge.
Clarity on further rate action may take time to emerge.
“We are headed for a long pause. Interest rate cut is unlikely in this calendar year. The first cut may take place in January-March 2024, or in the quarter after that, depending on inflation, GDP growth, and other factors,” says Joydeep Sen, corporate trainer (debt) and author.
Adds Vikram Dalal, managing director, Synergee Capital Service: “The stance remains ‘withdrawal of accommodation’. As the RBI relies on macro indicators, such as inflation and growth, and external events, it could require another six to nine months for clarity on the start of rate reduction.”
Impact on bond yields
The yield curve is flat.
“Shorter-end bond yields have increased as the rate corridor has risen. Mid- to long-maturity bond yields have eased, discounting lower inflation, less adverse global factors (inflation and rate hikes), demand for bonds from mutual funds and insurers in April, and the market pricing in the end of the current rate hike cycle and a rate cut in the future,” says Sen.
The hike in the repo rate by the RBI over the past year benefited shorter-duration debt funds.
Liquid funds have, on an average, given a return of 6.15 per cent over the past year.
While longer-duration funds should theoretically suffer in a rising interest rate scenario, these funds have given a return of 12.43 per cent over the past year.
This is due to the 10-year benchmark yield declining from 7.6 per cent in June 2022 to around 7 per cent currently.
“Long-term yields will likely remain around the current levels for an extended period. Short-term bond yields may fall due to the RBI’s reluctance to permanently remove surplus liquidity,” says Pankaj Pathak, fund manager, fixed income, Quantum Asset Management Company.
What should you do?
Many investors may be tempted to invest in longer-duration debt funds on seeing one-year returns.
If yields fall further, investors could profit. However, entering these funds with a short horizon could prove risky. Yields may rise if inflation hardens.
If you are concerned about fluctuating yields and don’t want to expose yourself to significant duration risk, stick to shorter-duration funds.
These schemes, with duration between one and three years, offer a favourable risk-reward ratio, with the average Yield-to-Maturity (YTM) for short-duration funds being at 7.33 per cent (May 31, 2023).
“Investors should opt for shorter-duration funds as the yield curve is flat. They can transition from short to long-duration funds when the yield curve normalises,” says Dalal.
Adds Sen: “At this juncture, the yield curve is remarkably flat. The yield on three-year, five-year, and 10-year bonds are similar. Hence, investors should align their investment horizon with the fund’s portfolio maturity. While some market segments advocate investing in long-maturity bonds, the longer end has already rallied, and the scope for further rally is limited,” says Sen.
Factors to consider
When choosing a scheme, pay attention to portfolio credit quality and expense ratio.
If you wish to further reduce risk, consider investing in a corporate bond fund, which invests 80 per cent of the portfolio in bonds of the highest quality.
“For long-term fixed income allocation, investors could opt for dynamic bond funds. Here, the fund manager can invest in either short- or long-term debt instruments depending on the interest-rate outlook,” says Pathak.
Target maturity funds (TMFs) offer exposure to high-quality bonds at a low cost.
“Align your horizon with the fund’s maturity. Volatility risk is mitigated if you hold these funds till maturity,” says Sen.
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Feature Presentation: Aslam Hunani/Rediff.com
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