Opt for long-duration, gilt funds to gain from interest rate cuts

Go for the flexibility of dynamic bond funds if you are unsure about direction of rates

The Interim Budget sprang a positive surprise on the fiscal deficit front, infusing buoyancy in the bond markets and bringing bond yields down. The 10-year benchmark bond yield fell by 8 basis points to 7.06 per cent on February 1. Financial advisors believe that debt funds are in a sweet spot.

“The Interim Budget gave bonds a fresh lease of life as the fiscal deficit and the gross borrowing numbers came in lower than market expectations. The fiscal deficit for Financial Year (FY) 2024-25 has been projected at 5 per cent against market expectations of 5.30 per cent and gross borrowing at Rs 14.13 trillion against market expectations of Rs 15.2 trillion,” says Puneet Pal, head of fixed income, PGIM India Mutual Fund (MF).

When the government borrows less, the pressure on bond yields reduces.

Rate cuts coming

The Reserve Bank of India (RBI) may cut the repo rate in the second half of 2024, as inflation softens and cuts begin in the United States (US). “Reversal of the interest rate hike cycle, both globally and in India, is a matter of time. Inflation, though a little higher than respective central banks’ targets, is easing. RBI is likely to start rate cuts in the second half of the calendar year once it has an indication of sustained easing of Consumer Price Index (CPI)-based inflation,” says Joydeep Sen, corporate trainer and author.

Time to increase duration

With the interest-rate cycle about to turn, investors may consider increasing their allocation to longer-duration funds. When yields go down, bond prices rise to result in mark-to-market gains in debt fund portfolios. Bonds with longer residual maturity gain more. Long-duration funds and gilt funds, which typically hold long-duration bonds, benefit more. Since they mostly hold government securities, they also carry little credit risk.

“We have been recommending increasing exposure to longer-duration funds since the 10-year bond yield was trading at around 7.40-7.45 per cent,” says Sandeep Bagla, chief executive officer, TRUST MF.

Adds Pal: “Investors with medium to long investment horizons can consider funds having a duration of three to four years with predominant sovereign holdings as they offer a better risk-reward currently.”

 

Contrary view

Some fund managers hold a different view. “Bond markets appear to be in a neutral zone with yields anticipated to remain volatile and within a range, rather than trend in a specific direction,” says Manish Banthia, chief investment officer - fixed income, ICICI Prudential Asset Management Company. He recommends schemes with short duration along with an element of accrual. “Accruals may become attractive as corporates tap the bond market for capital.”

According to Banthia, duration needs to be played tactically. “Active duration management is the way forward for navigating the fixed-income markets as global factors may have a push and pull effect on domestic yields. The probability of rate cuts is low.”

Keep an eye on your goals

Investors should factor in their own financial goals and risk appetite before changing their debt portfolio. “Your decisions should not be driven by your view on the market but by your objectives, risk appetite, and time horizon. If your horizon is, say, one month or a few months, you should not go for long-duration funds,” says Sen.

Investors may also go for target maturity funds with residual maturity of more than five years. They, too, invest in high-quality bonds.

Ideally, one should have a horizon of more than three years when investing in longer-duration funds. A lower time frame would carry risk. If rates remain range bound, returns will be postponed. If rates rise contrary to expectations, returns will turn negative. This allocation should also be a limited portion of the debt fund portfolio (depending on risk appetite).

Dynamic bond funds are another option. “Here, based on the market environment, the fund manager has the flexibility to actively manage duration and instruments with varied credit ratings to handle interest-rate fluctuations,” says Banthia.

Those wary of taking interest rate risk should stay invested in shorter-duration funds. Go for funds with a low expense ratio and high credit quality.