Invest in these Debt Funds to benefit from rate hikes

By Ravi Samalad |  21-02-22 | 

Debt fund investors enjoyed double-digit returns in the past as interest rates went southwards.

To battle inflation and to revive and sustain economic growth, the Reserve Bank of India (RBI) has kept the policy repo rate unchanged at 4%, signaling an accommodative stance.

Going ahead, the central bank is expected to raise policy rates in a staggered manner. As rates rise, long-term debt funds will have a bumpy ride. We asked experts how investors should invest in a rising interest rate scenario. 

Spread your portfolio across short to medium term maturity - Dhaval Kapadia, Director - Portfolio Specialist, Morningstar Investment Advisers India.

Although RBI hasn’t raised interest rates and may not do so in the immediate term (next 3 to 5 months), bond yields, across short-, medium- and long-term maturity segments in the debt market have been on an upward trajectory over the past couple of quarters. This is due to RBI measures to reduce excess liquidity in the banking system, which has resulted in short tenor rates (up to 3 yrs) moving up and concerns around possible rate hikes and additional government borrowing have resulted in yields on medium to long tenor (4 years and above) bonds moving up. Over the past one year, the 5-year G-Sec yield has risen by 40bps (0.4%) from 5.49% to 5.89% and the 10-year G-sec yield by 73bps (0.73%) from 5.95% to 6.68%. Similarly, the 1-year T-bill yields around 4.45% currently.

On account of the jump in yields, certain segments of the yield curve are looking fairly attractive. The term spread, i.e. the difference in yields across various maturity buckets is quite high for 5 to 10 year G-secs vs 1-yr T-bills. The spread or difference in yields for the 5-yr & 10 yr-Gsecs vs 1-yr T-bill currently stands at 1.45% and 2.23%, respectively. These spreads are higher than their long-term averages. Accordingly, one can consider investing a portion (30-40%) of the debt portfolio in the medium to long duration segment via a combination of low expense Target Maturity Funds (such as 2027 Gilt index funds), Long Term Bond Funds and Constant Maturity Funds. Around 35%-45% can be invested in short duration Banking & PSU Funds and the remainder in moderate Credit Risk strategies, where yields are looking reasonably attractive.

What are target maturity passive debt funds?  

Go for roll down funds of up to 3-year maturity – Sandeep Bagla, CEO, Trust Mutual Fund.

Given the high inflation and elevated commodity prices, most investors were expecting rapid hikes in domestic overnight rates. The central bank has made it clear that it prefers to maintain a low real rate regime to enable the domestic economy to reach its full potential. It implies that RBI is likely to raise rates at a slow and gradual pace.

Bond yields had risen in anticipation of rate hikes and have softened a bit. An ideal strategy for debt mutual fund investors would be to deploy a substantial chunk of their investments in funds like Short Term Funds and Banking & PSU Debt Funds, which have moderate duration but significantly higher interest income than liquid funds. Interest rates are expected to go up but gradually. In such a scenario, roll down funds up to 3-year maturity also make sense. While Liquid Funds continue to generate around 3.35%, the above strategy could generate 5-6% without much risk over a one-year investment horizon.

Avoid Long Term Debt Funds - Harshad Chetanwala, Co-Founder,

At present, investors should consider investing in Liquid, Ultra-Short or Low Duration Debt Funds as interest rates are expected to increase in the future. Whenever the interest rate goes up, it has an implication on the bond price which pushes down the Net Asset Value (NAV) of these funds. The higher the average maturity of the fund, the higher is the impact. One should avoid locking their investment in long term debt funds at this moment. Once the interest rate starts increasing investors can gradually invest in Medium Duration debt funds. The returns on debt funds have been low and may take some more time to reach the returns in the horizon of 6 to 8% depending on the kind of debt fund. 

Investors having a defined investment horizon can invest in roll down strategies. - Amol Joshi, Founder, PlanRupee.

In a rising interest scenario, Floating Rate Funds are a preferred choice.

Should you invest in Floating Rate Funds? 

Investors with a defined investment horizon of say  2, 3, 5 years, and so on may also opt for roll down funds. These funds will have continuously falling maturity as time goes by & will have a lesser impact on rising rates. Also, the roll down structure delivers the desired outcome if held till the completion of roll down period. Returns in Floating Rate Funds will vary based on the holding period (investment period) and also the portfolio yield and rates trajectory to some extent.

Roll down funds or Target Maturity Funds are likely to deliver in line with the net yield of the portfolio. Please also be mindful of other factors like re-investment risk and credit risk of the portfolio. To their credit, most of these funds invest in highest rated (highest grade) debt securities hence these risks while being there, are less likely to manifest.


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