Bond fund investors must follow these 4 ways to beat inflation: Expert

We head into financial year 2021-22 (FY22) in the shadow of the second wave of the Covid-19 pandemic. Nevertheless, we should expect that this year will be post-Covid supported by the vaccination drive. Growth should bounce back, aided by higher government spending and fiscal deficit.
 
This implies a normalisation of monetary policy, i.e. the extraordinarily easy liquidity and low rates should be reversed this year. The Reserve Bank of India (RBI) has maintained an accommodative stance to aid growth. With growth returning naturally and through higher deficit spending, the need for such monetary support is no longer as strong. We expect RBI to withdraw liquidity and start raising the overnight rates this year.
 
This view of rising rates is also supported by the global environment — where expectations of stronger growth are leading to higher commodity prices and a global shift as markets expect interest rates to rise sooner in several major global economies. The recent rise in wholesale inflation to multi-year highs also raises the risk of inflation spreading more broadly and the possibility that RBI may have to act sooner than expected. Expectations of domestic rate normalisation and the global shift to higher yields has resulted in Indian bond yields rising over the last three months.
 
However, RBI faces a challenge in its other role as merchant banker to the government. It hopes that the increases in short-term interest rates do not percolate to the longer end of the yield curve as that affects the borrowing cost of the government. This has led to the introduction of new programmes to support bond markets such as the Government Securities Acquisition Programme (GSAP).
 
Rising interest rates are often viewed as being difficult for investing in bonds. That is not always the case. For example, very-short-duration bonds benefit from reinvestment, the process of redeployment of maturing bonds into higher yielding instruments as rates rise. Naturally, there is a trade-off between duration and reinvestment with longer-duration bonds affected by mark-to-market risk with lesser reinvestment opportunities. This strategy is fundamentally different from a falling interest rate environment, where longer-duration strategies tend to outperform.

 
As mentioned above, RBI’s actions to stabilise the longer end of the yield curve means that these bonds — which are higher yielding in nature — also have better protection from a sell-off. These two opportunities — in very short-term and long-term bonds — are what we use at Axis Mutual Fund in building our portfolios at this time. This strategy is referred to as barbell as it weighs both ends of the yield curve.
 
We should also expect that the current Covid surge is temporary and, thus, with an outlook of the next few years, improving macroeconomic conditions should lead to better corporate performance. In turn, this would lead to outperformance of the non-AAA segment of the market (credit segment). The period from 2018 to 2020 was tough for credits bookended by IL&FS and Covid. But in the second half of FY21 a couple of leading credit rating agencies reported more rating upgrades than downgrades.
 
During the past year, one challenge for fixed income investors was to find bonds that yield more than inflation. As yields normalise, we are seeing more opportunities to beat inflation. For investors in bond funds, these strategies — better yields than inflation, reinvestment, barbell strategies, and credits — are where we see the best opportunities.
 
The author is head, fixed income, Axis AMC