Avoid longer-duration funds as interest rates may harden: Analysts

Shorter-duration ones will see lower mark-to-market impact

The yield on the benchmark 10-year government securities (G-Secs) crossed the 6.5 per cent mark on January 4. With interest rates likely to harden in 2022, retail investors need to be careful while investing in debt mutual funds (MFs) or else they could face losses.
 
Inflation, global factors driving yields
 
One factor that has contributed to the recent hardening of yields is the higher-than-anticipated supply of SDLs (state development loans). Another is high energy prices.
 
Global interest rate movements have also played a part. “Globally, yields have hardened due to expectation of faster normalisation by central bankers of advanced economies,” says Kaustubh Gupta, co-head, fixed income, Aditya Birla Sun Life Asset Management Company (AMC).
 
The US 10-year G-Sec yield has moved from around 1.40 per cent to 1.65 per cent in the past 15 days. The Omicron variant of coronavirus was expected to lead to a significant downturn in the economy, forcing global central bankers to continue with their accommodative stance. However, the view emerging now is that this variant may not be as lethal as the Delta variant. This has resulted in bond yields reversing course in developed markets.

 
The Reserve Bank of India’s (RBI) non-intervention is also allowing yields to harden. “For now, the RBI is shying away from intervening in the upward adjustment in long rates by stopping OMO (open market operations) purchases despite its promise to carry out at least a similar amount as in the last fiscal year,” adds Gupta.
 
Limited, gradual rise expected
 
One factor that could have an impact on the 10-year G-Sec yield is the government’s borrowing numbers that will be revealed in the Union Budget. “Our base case is that the government will go for a fiscal deficit of 6-6.2 per cent, so the 10-year G-Sec yield should stabilise between 6.5 per cent and 6.6 per cent. If the fiscal deficit is very high – in the 6.2-6.5 per cent range – we could probably see the 10-year G-Sec yield inching towards 6.6-6.7 per cent,” says Devang Shah, co-head, fixed income, Axis Mutual Fund.
 
Fund managers think it is unlikely the 10-year G-Sec yield will go beyond 6.7 per cent over the next 6-12 months. “We don’t see it touching 7 per cent since a lot of negatives, like the massive supply of government bonds and two repo rate hikes in the next financial year, are already priced in. Only if the government wants to push growth and goes for a significantly higher fiscal deficit, or there are more than two rate hikes, would the benchmark yield rise beyond 6.7 per cent,” says Shah.
 
Where you should invest
 
Investors should confine themselves to the shorter end of the duration curve if they have an investment horizon of up to one year. “Invest in shorter-duration debt funds having portfolio duration up to one year,” says Viral Bhatt, founder, Money Mantra.
 
In a rising interest rate scenario, the portfolios of these funds get reset faster. “As the shorter-term bonds in these portfolios mature, the money gets invested in higher-yield bonds,” says Sen.  
 
Floating rate debt funds, according to Bhatt, are another good option.
 
Those who plan to invest for at least three years may look at short-duration funds or credit risk funds (but to a limited extent). “The cycle of defaults is behind us. Corporates did a good job of managing their debt during the slowdown from March 2020 until now,” says Sen.
 
Adds Shah: “These funds are offering a yield-to-maturity (YTM) of 6.5-7 per cent currently. Their duration is less than one-and-a-half years, so they will have low interest-rate volatility.”