Fixed Income: Go for debt funds with lower duration profiles

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With interest rates set to rise due to spiralling inflation, retail investors will perforce have to tweak their existing debt funds portfolio and plan new investments based on the time horizon. When interest rates rise, the value of existing investments in debt funds falls because then investors prefer to invest in a fund with higher rates.

Analysts expect the Reserve Bank of India (RBI) to hike the repo rates by 100 basis points in the current financial year. In fact, the bond market is factoring a 200 basis points hike in repo rate in the next two years, with terminal repo rates at 6%. The one-year bond yields are trading in the range of 5.10 – 5.20% and two-year rates are trading in the range of 5.80 – 5.90%.

Debt fund strategy

Murthy Nagarajan, head, fixed income, Tata Mutual Fund, says for up to one month, investors should be in ultra-short term bond fund, one-month to three months in money market fund, four to six months in floating rate fund and above one year in banking and PSU fund, corporate bond fund. “If investors have a three-year horizon, then they can invest in five-year constant maturity funds, income fund and gilt funds to take advantage of indexation and higher accruals in these funds,” he says.

Similarly, Devang Shah, co-head, Fixed Income, Axis Mutual Fund, says for short term parking solutions, investors may consider ultra short term and money market schemes. “Investor who are looking at the medium term, may consider credit funds and those with a long-term investment horizon may consider target maturity funds maturating in 2027 and beyond,” he says.

In a rising rate scenario, investors can look at floating rate funds because these funds can switch to the newer issuance of securities which are at higher interest rates and the older ones are automatically replenished. “The ideal funds would be liquid, cash or even a floating rate fund in this kind of a scenario to avoid losses or volatility in the fixed income space,” says Santosh Joseph, founder, Germinate Investor Services LLP.

Rising bond yields

The bond yields have moved up over 100 basis points over the last 10 months and at the current levels, much of the potential repo rate hikes are already priced. Pankaj Pathak, fund manager, Fixed Income, Quantum AMC, says conservative investors should stick to short-term debt categories such as liquid and money market funds which tend to gain from rising interest rates. “Investors with longer time horizon and higher risk tolerance can look at dynamic bond funds which have the flexibility to respond to changing macro environment,” he says.

Tweaking your portfolio

While bond yields at this point of time have factored in most of the negatives, there could be volatility due to the ongoing Russia-Ukraine conflict. “Investors’ portfolio should be tilted more towards funds which are running a maturity of less than two years. Investors should reduce exposure to funds which are running average maturity of more than five years in their portfolio unless they have a time horizon of more than three years,” says Nagarajan.

Reinvestment risks

The reinvestment risk in a rising interest rate scenario is that the investor will only be able to make the most of it once the entire rate hike cycle is complete. Once investors feel that the interest rate cycle has peaked out, it would be better to move into medium-term or long-term duration funds, but till such time, it will be better to be on the low end of the curve.


* For up to one month investment, go for ultra-short term bond fund
* For one month to three months investment, go for  money market fund
* The bond market is factoring a 200 basis points hike in repo rate in the next two years, with terminal repo rates at 6%. One-year bond yields are trading in the 5.10 – 5.20% range
* Floating rate funds can switch to newer issuance of securities with higher rates
* Those with a long-term horizon may consider target maturity funds

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