With the RBI calling a sudden meeting of the Monetary Policy Committee (MPC), making worried noises about inflation and raising the repo rate from 4% to 4.4% last week, the rate hike cycle interest in India has officially begun.
But “officially” is the key word, because the rate hike cycle for bond market investors started long before that. Markets usually shoot first, then ask questions. Thus, Indian bond markets have been anticipating this official rate hike for many months.
The table accompanying this article tells you that in the year to April 30, 2022, before the RBI officially announced its rate hikes, market yields across the range of government securities had already risen by 110 to 145 basis points. The official rate hike only pushed market returns a little higher.
While the RBI is just starting to take note of inflation, market watchers expect MPC to continue its official rate hikes for the rest of the year. Current expectations call for a further 75-100 basis point hike in the repo rate in FY23, bringing it back to (or slightly above) the pre-Covid level of 5.15% . The trajectory of rates thereafter will depend on the evolution of inflation and economic growth.
The investor’s dilemma
This puts investors in debt funds in a difficult position.
If they can be sure that the bond markets have already priced in all the upcoming RBI rate hikes, then they should shift their money into long-term gilded funds, which are now trading at yields of 7- 25-7.45%. This would allow investors to lock in to the safest bonds in the market for the next 5-10 years at 7.25-7.5%, which is not a bad deal at all.
But this seemingly simple strategy comes with a risk. If actual RBI rate hikes exceed current estimates of 5.15-5.40% and market interest rates move higher, 5-10 year bonds would see significant price declines over the next few years. or two years ahead, resulting in long-term net asset value losses. gold backgrounds. This scenario is not very unlikely. India’s repo rate stood at 6.5% in 2018-19 and hit 8% in the 2014 rate hike cycle.
Given that it would be risky to bet on either outcome, what can bond mutual fund investors do? Well, they can consider three strategies.
Investors who are unsure when they will need to withdraw their money and those looking for short-term parking can consider investing in ultra-short debt funds and floating rate debt funds. Ultra-short debt funds invest in Indian government treasury bills, commercial paper issued by companies and certificates of deposit issued by banks. In a cycle of rising rates, the instruments they own mature quickly and are replaced by higher yielding instruments. Among ultra-short debt funds, it is better to choose those that allocate more to safer avenues such as treasury bills and certificates of deposit, while being very demanding with corporate papers. HDFC Ultra Short and Kotak Savings are two funds to consider.
Floating rate debt funds have a mandate to invest in bonds with flexible interest rates that increase when the yield of a benchmark index increases. In a rising rate cycle, floating rate loan funds not only allow you to earn higher interest yields as rates rise, but they also protect you from some of the downsides to which the funds fixed rate are subject. When selecting floating rate debt funds, it is important to check the portfolio’s actual exposure to natural or synthetic floating rate instruments, given the scarcity of such bonds in the Indian market. Aditya Birla Floating Rate Fund and ICICI Pru Floating Rate Fund can be considered here.
Know your options
Short term: Ultra-short debt funds and floating rate debt funds
Medium term: passive funds investing in government development loans
Long-term: 10-year constant-maturity golden funds
Medium term investment options
If you are looking for medium-term investment options that can offer better returns than your bank or NBFC FD, now is a good time to buy passive funds investing in State Development Loans (SDLs). With five-year bond yields in the market rising sharply since the RBI rate hike, there is only a 25bp spread between the 5- and 10-year g-secs. SDLs can give you better returns than g-secs because state governments borrow at a higher rate than the Center. The Kotak Nifty SDL 2027 Equal Weight Index Fund and the Aditya Birla Sun Life Nifty SDL 2027 Fund are good options.
If you’re looking for debt options for your 10-year goals or your retirement portfolio for 10+ years, then now would also be a good time to start investing in 10-year constant maturity golden funds. These are debt funds where the fund manager always holds g-secs with an average maturity of 10 years, regardless of the rate cycle. However, the main risk associated with investing in such funds is the possibility of large losses in net asset value in the short term as rates rise. A long holding period usually compensates for these losses. But given that we may not yet be at the peak of rising market returns, it would be good to only deploy some of your long-term money into such funds now, with the intention of invest more at higher returns. Ten-year constant maturity funds run by SBI and DSP are good bets.
May 07, 2022