As we come towards the end of the rate reduction cycle and the beginning of the normalisation of monetary policy over the course of next 12 to 18 months, fixed income investors are getting anxious about the impact on their investments.
We try and address these concerns of fixed income investors regarding the potential impact of the changing Interest rate cycle.
Adjusting portfolio duration
Interest rates generally revert to the mean, which means that they are cyclical. Thus, the duration- play in fixed Income investment is a cyclical game. In India, over the last 20 years, we have seen 4-5 cycles with interest rates moving in a cyclical way. During the course of these cycles, the benchmark yields have ranged from 5-9 percent, but debt mutual funds have been able to successfully navigate this volatility, thus generating decent returns for investors over a period of time. In an actively managed open-ended fund, investors need not worry about the cyclical movement of rates. In other words, during a change in the interest rate cycle, actively managed funds tend to adjust their portfolio duration in line with the outlook on rates so as avoid having a negative impact on returns.
Further, the market has deepened and evolved over time and presently market players have the option of using different instruments which can be used to generate alpha even in an environment of rising rates. These instruments are Overnight Indexed Swaps and Floating rate Bonds, which help in effective duration management of the portfolio.
The good thing is that, over the last five years, since the adoption of the flexible inflation targeting regime by the Reserve Bank of India, the volatility in rates and consequently in yields has come down. The average Inflation rate from October 2016 till February 2020 (before COVID) was 3.8 percent, down from the average of 7.3 percent from January 2012 to September 2016. This has resulted in positive real returns to debt Investors over the last five years. The inflation targeting framework has been extended for the next five years till March 2026. This also bodes well for macroeconomic stability. The government has also been working to list select Indian sovereign securities on global bond benchmarks, which can open a new avenue for attracting global funds into Indian bond markets, thus deepening it further and adding to its efficiency.
Global rates to remain low
Globally, rates are expected to stay low for longer, as countries struggle with uneven growth recovery.
As the current rate cycle normalises, we would suggest that Investors continue with their asset allocation to fixed Income and not worry about rate cycles, as actively managed funds will be able to navigate through volatility as we have seen in previous rate cycles. Within the fixed income allocation, investors can probably give a higher weightage to short duration products and reduce their allocation to long duration schemes. But do not reduce your fixed income allocation, as it has been demonstrated time and again that staying true to asset allocation yields consistent returns over a period of time.
Disclaimer: The views of the Fund Manager should not be construed as an advice and investors must make their own investment decisions regarding investment/disinvestment in securities market and/or suitability of the funds based on their specific investment objectives and financial positions and using such independent advisors as they believe necessary. None of the information contained in this document shall be constituted as a recommendation to buy or sell any particular security. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully