Keep bulk of your portfolio in short- to medium-duration debt funds

In its monetary policy review meeting that ended on July 31, the US Federal Reserve (Fed) opted to keep interest rates unchanged, but hinted at a rate cut in September. The Reserve Bank of India (RBI), too, left the benchmark repo rate unchanged at 6.5 per cent and kept the policy stance unchanged on Thursday.

Shallow rate cut likely

The US Fed appears to be considering adjusting rates downwards in response to lower inflation expectations, easier labour market conditions, and a slowing economy. “However, inflation is higher than target levels and equities are hovering around all-time high levels. The US Fed is unlikely to embark on a serious rate cutting cycle unless the economy falls off the cliff,” says Sandeep Bagla, chief executive officer (CEO), TRUST Mutual Fund.

The labour market data released last Friday (August 2) in the US was much weaker than expected. This has raised concerns of a rapid slowdown in the US. The markets have started pricing in accelerated rate cuts by the Fed for this year.

In India, growth remains strong and inflation remains above the target level of 4 per cent. “The policy statement was decisive in communicating RBI’s mandate to align headline inflation closer to the 4 per cent target. This clearly pushes back expectations of RBI reacting to short-term market volatility and US Fed actions in changing the policy stance in the near term,” says Rajeev Radhakrishnan, chief investment officer (CIO)-fixed income, SBI Mutual Fund.

Once rate cuts begin in the US and flows begin to be affected, however, the RBI may take cues from the US Fed. But the rate cut cycle in India is expected to be shallower than in the US. “The rate differential between India and the US has shrunk considerably. Therefore, the domestic rate cut cycle may be shallower. While the Fed may cut rates by 150 basis points (bps) or more by the end of 2025, the RBI may cut by about 50 bps during this period,” says Mahendra Kumar Jajoo, CIO–fixed income, Mirae Asset Investment Managers (India).

Jiral Mehta, senior research analyst, FundsIndia, believes there is room for the RBI to reduce rates by 50 to 75 bps over time.

Three- to seven-year segment attractive

The longer end of the yield curve has already discounted a shallow rate cut cycle. “Due to tighter liquidity, the yield curve has become flat. The medium to short end of the curve has more room to react when liquidity conditions improve. The belly of the curve with a horizon of three to seven years becomes more attractive. The onset of the rate cut cycle may lead to steepening of the yield curve, resulting in yields falling faster in this segment,” says Jajoo. He adds that low, short-duration and corporate bond funds appear attractive.

Mehta concurs. “The three-five-year bond yields remain attractive. We prefer funds with short duration (one-three years) or target maturity funds (three-five years) and funds with high credit quality (above 80 per cent AAA exposure),” she says.

Mehta adds that those who have a one-two-year timeframe and are willing to tolerate higher volatility may consider investing tactically in long-duration debt funds with high credit quality.

Match the duration

To minimise risk, invest in a debt fund whose duration matches your investment timeframe. Buy a target maturity fund (TMF) if your timeframe and its residual tenure match.