More rate hikes lined up, yields may have peaked: SBI MF's Radhakrishnan

He reveals why fixed maturity plans (FMPs) remain relevant, notwithstanding the emergence of target maturity funds (TMFs) in the 'predictable return' space in debt

Bond yields may have already peaked as the market prices in the next round of rate hikes, says Rajeev Radhakrishnan, chief investment officer-fixed income, SBI Mutual Fund. In conversation with Abhishek Kumar, Radhakrishnan reveals why fixed maturity plans (FMPs) remain relevant, notwithstanding the emergence of target maturity funds (TMFs) in the ‘predictable return’ space in debt. Edited excerpts:

Yields have risen to adequate levels. Do you see good days ahead for debt fund investors?

I think this is the right time to invest in debt funds. Yields are attractive in absolute terms and also relatively better than other investment options. It needs to be appreciated that the yield curve currently provides a positive real return on a forward-looking basis, based on the expected one-year-ahead inflation.

As inflation eases, do you see the Reserve Bank of India (RBI) pausing rate hikes sooner than expected? Have yields already peaked?

We expect the policy rate to peak at 6.5 per cent. Inflation is still beyond the comfort zone. The RBI has signalled its primary goal is to bring down the rate of inflation to below 6 per cent and then steadily lower it to 4 per cent. Given inflation is expected to hover around 5.25-5.5 per cent on average next year, the RBI is expected to hit pause at 6.5 per cent, which ensures a 1 per cent positive real policy rate.

Yields may have peaked, given that the next rounds of rate hikes are already priced in. In the months to come, volatility is expected. But directionally, there is a high degree of confidence that market yields will likely be lower during the same period next year, as opposed to now.

What is the right option to lock in returns for the long term?

Fixed income allocation is a function of investors’ risk appetite and liquidity requirement. If an investor is looking for predictable returns with the least amount of risk, then a TMF or an FMP is the right alternative. If the investor is fine with a slightly higher interest rate risk, then actively managed schemes like dynamic bond funds and government securities (G-secs) can also be considered.

Do you think FMPs are still relevant since we have a similar, albeit better option in TMFs?

TMFs may have the liquidity advantage as they are open-ended, but the predictability of returns is still higher in FMPs. Given there is no inflow or outflow from FMPs before maturity, there is no portfolio churn.

Of course, the reinvestment risk is there, but that can be mitigated through zero coupon bonds or G-sec STRIPS (separate trading of registered interest and principal securities). For this reason, FMPs should be the ideal option when one wants predictable returns and doesn’t require the money before maturity.

Why are inflows into debt funds still negative, notwithstanding higher yields?

The core problem in fixed income is that investors subscribe to past returns, and do not make debt a part of their asset allocation strategy. Investors have burned their fingers many times in trying to time the debt market in the past.

The past decade has seen both event-based interest rate shocks in 2013 and credit-related shocks in 2019-20 that could have resulted in suboptimal outcomes for allocations, based on past returns and not governed by risk tolerance and adequate investment time horizon.

There is a need for a paradigm shift in the way people approach allocations in fixed income.

What should the strategy be when the rate-cut cycle starts?

It depends on the category and how long you need to stay invested for tax benefits. I will not advise too much of churning.

When the rate-cut cycle is closer to the end, investors should look to lower their exposure to longer duration funds by reassessing their overall investments.

Maybe a larger incremental allocation to the shorter end of the curve by investing in schemes like the money market needs to be adopted at that time.

One can also leave it to the fund managers. In G-sec and dynamic bond funds, fund managers take these calls themselves and shift the portfolio in keeping with the rate cycle.