Shorter-duration funds a good bet amid rising rates, say analysts

The yield on the benchmark 10-year government security (G-Sec) has seen a sharp spike in the recent days. From 6.66 per cent on February 18, it has risen to 7.22 per cent (April 13).

In its April 8 monetary policy review, the Reserve Bank of India (RBI) signalled that from being supportive towards growth, its focus would now shift towards reining in inflation. Debt mutual fund investors need to realign their portfolios as a result.

Rising yields

The government’s borrowing programme for financial year 2022-23 (FY23) was announced in the Union Budget on February 1. “This was higher than market expectations, causing the 10-year G-Sec yield to rise,” says Joydeep Sen, corporate trainer (debt markets) and author.

The Russian invasion of Ukraine caused prices of crude oil and several other commodities to flare up.

Inflation has proved far stickier than anticipated. The March consumer price index (CPI)-based inflation came in at 6.95 per cent, the third straight month when it exceeded the RBI’s inflation mandate of 4 per cent plus or minus 2 per cent. With inflation becoming a global concern, central banks across the world are hiking rates.

“Globally, interest rates are moving up and this is putting pressure on interest rates in India as well,” says Vaibhav Porwal, co-founder, Dezerv, a wealth-tech firm.

Changing policy focus

In the monetary policy review announced on April 8, the RBI did not change its stance from accommodative, but said it would focus on “withdrawal of accommodation”. It kept the repo rate (4 per cent) and the reverse repo rate (3.35 per cent) unchanged. However, it introduced a standing deposit facility (SDF) at 3.75 per cent.

“The only difference between the reverse repo and SDF is that in the former there is a collateral. There is an exchange of government securities between the bank and the RBI. The SDF is an uncollateralised transaction. Here, banks will simply park their surplus money with the RBI for one day at 3.75 per cent,” says Sen.

The lower bound of LAF (liquidity adjustment facility) has been effectively raised from 3.35 per cent to 3.75 per cent.

“The RBI is incentivising banks to park excess liquidity with it and thus reduce liquidity within the banking system,” says Porwal.

Brokerages now expect aggressive rate hikes. While most expect four, some expect as many as eight.

“Effectively, the interest rate hike cycle has started. We expect 100 basis repo rate hikes in calendar year 2022,” says Manish Banthia, senior fund manager-fixed income, ICICI Prudential Asset Management Company (AMC).

The quantum of rate hikes by the RBI will depend on the inflation trajectory. “If prices of crude oil and other commodities do not moderate, and inflation stays elevated, the RBI may have to go in for aggressive rate hikes. But if inflation cools within, say, six months, 75-100 basis points of rate hikes may suffice,” says Sen.

Debt fund categories you look at

Investors may invest in floating-rate funds. “We believe that due to the rising interest rate environment, floating rate bonds may outperform all other fixed-income instruments. These bonds offer a coupon tied to a benchmark rate like the MIBOR or the T-Bill, which resets periodically to factor in changes in interest rate,” says Banthia.

Another category suited for this environment is target maturity funds. “The investor has good visibility on returns in these funds. At the time of entry, he can look at the portfolio’s yield-to-maturity (YTM). If rate hikes happen, there will be a mark-to-market impact on these funds as well. But as long as the investor holds them till maturity, he will get returns close to the YTM,” says Sen. All that the investor needs to do is select a fund whose tenure matches his investment horizon.

Porwal says investors can generate 6 per cent plus return in target maturity funds that have a three- to five-year maturity.

When interest rates were falling, yields at the shorter end had fallen more. Now, as the cycle reverses, yields at the shorter end are expected to rise more. However, since shorter-maturity funds have a lower portfolio duration, the mark-to-market impact gets contained. “In these funds, bonds mature faster, so reinvestment at higher rates happens more quickly. This helps to improve returns over time,” says Porwal.

Those you may avoid

Most retail investors may avoid longer-duration funds and gilt funds. “These funds will see significant mark-to-market risk in a rising interest rate environment,” says Porwal. Hold these funds only if you have a 10-year horizon and will not be affected by high volatility in the interim. 

Investors who have a low to moderate risk appetite should also stay away from credit risk funds. “In a rising interest rate environment, businesses that are unable to raise money easily can come under stress,” says Porwal.

He adds that currently the spread between ‘AA’ and ‘AAA’ bonds is less than 100 basis points, so investors won’t get compensated adequately for the risk they take in these funds.