Rate hike: What should debt mutual fund investors do?

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Money market pundits say a rate hike is likely in the next few months. Then how can long duration funds and gilt funds gain in the last one month? That too, better than medium duration and shorter term funds. After all, long term debt funds are supposed to lose money during rising interest rates.

Long duration funds have offered 1.11% returns in the last one month, followed by gilt with 10-year constant duration funds and medium to long duration funds.

“In the last one month, longer term bonds have benefited from a relatively lower increase in yields compared to shorter maturities (yield curve flattening) and spread compression in long term SDLs and corporate bonds over Gsec,” says Pankaj Pathak, fund manager, Quantum Mutual Fund.

In the month of October, the 10-year benchmark government bond yield (Gsec) surged 17 basis points from 6.22% on September 30 to 6.39% on October 29. As of today, the bond yield stands at 6.36%. Since September 20, 2021, the 10-year government bond yield has moved up by a cumulative 24 basis points.

This increase in bond yields has impacted the returns from the shorter term debt mutual funds. Much of the yield variation is being attributed to a steep rise in crude oil price and normalization of liquidity operations by the RBI. There is uncertainty around the rate scenario and the monetary policy. Mutual fund managers believe that the uncertainty will stay for a while.

“Given the pace of economic growth and persistent inflationary environment, global central banks are likely to start the normalization process sooner than expected. That said, central banks will not move forward until they are completely assured that their respective economies are strong enough and can withstand a number of rate hikes over a period of time. We also believe that the upcoming rate normalization cycle could be shallower than previous rate hiking cycles despite elevated inflation down the road,” says Dhawal Dalal CIO-Fixed Income Edelweiss Mutual Fund.

However, fund managers are not rooting for long term funds despite the recent gains. They believe that the medium term bond funds are well placed in the current scenario but this doesn’t mean that these funds will continue to do well.

“We particularly like the 3-5 year segment of the government bond market which in our opinion, is already pricing much of the liquidity normalisation and a start of rate hiking cycle by end of this year. Given the steep bond yield curve, 3-5 year bonds offer the best roll down potential as well. We are restricting exposure to the longer segment due to risk from the rising crude oil prices and the absence of assured RBI buying,” says Pankaj Pathak.

Given the uncertainty and risks involved in some categories, fund managers believe that debt mutual funds should restrict exposure to longer-duration funds. For investors who want the least risk and have a shorter-term horizon, fund managers advise a combination of liquid and short term funds.

“We believe a combination of liquid to money market funds to benefit from the increase in interest rates in the coming months; along with an allocation to short term debt funds and/or dynamic bond funds with low credit risks should remain as the core fixed income allocation,” suggests Pankaj Pathak.

For longer-term debt mutual fund investors, fund managers believe that target maturity funds can be a good call.

“The AAA-rated CPSE curve continues to remain steep and offer value to investors in 5+ year spot even when the short-end of the curve could come under pressure. Based on that, we ask investors to focus on Target Maturity bond ETF/Index Funds maturing in the 5-11 year segment and investing in high-quality assets for their long-term fixed income asset allocation,” says Dhawal Dalal.

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