Good time to invest in debt funds as portfolio yields rise, say experts

Opt for a mix of shorter-duration, target maturity, and dynamic bond funds

One positive impact of rising interest rates has been that portfolio yields of debt mutual funds (MFs) have improved across categories. Their returns, which were muted over the past few years, are likely to turn around in the near future.

Rising bond yields  

The cumulative 90-basis-point (bp) rate hike and other policy tightening measures by the Reserve Bank of India (RBI) have pushed bond yields higher over the past six/seven months.

The 10-year government security (G-sec), which had touched a low of 5.75 per cent on May 22, 2020, is at 7.37 per cent currently.

Yields to maturity (YTM) of debt MF portfolios (which are mark-to-market, or MTM) have hence moved up.

Their return potential has also improved.

“The major component of debt fund return comes from accrual, which is much better today than a year ago,” says Pankaj Pathak, fund manager-fixed income, Quantum Asset Management Company.

Bond yields and prices move inversely. With yields moving up, bond prices are falling.

“While accrual has been improving, currently an adverse MTM impact is also taking place. Once the RBI’s rate-hike cycle ends and bond yields stabilise, the adverse MTM impact will end. That’s when debt-fund returns will improve,” says Joydeep Sen, corporate trainer (debt markets) and author.
 

Debt fund YTMs better than fixed-deposit (FD) rates

Since the bond market is forward-looking, bond yields had moved up sharply in anticipation of the RBI’s rate hikes. The 10-year G-Sec had moved to 7.12 per cent by May 2. All this while, the RBI repo rate remained at 4 per cent. Since May 4, the repo rate has risen by 90 bps. Meanwhile, the 10-year G-sec has moved from 7.12 per cent to 7.37 per cent — only 25 bps higher.

While bank FD rates have risen, they have not kept pace with the RBI’s rate hikes.

“System liquidity is still in surplus. Banks that expect credit offtake to improve have hiked their FD rates. But these rates will go up with a lag,” says Sen.

While the State Bank of India’s one-year FD rate is at 5.3 per cent, the one-year treasury Bill yield is at 6.37 per cent. Hence, YTMs of debt MFs are also looking better than bank FD rates.

Will YTMs rise further?

According to fund managers, the RBI is likely to continue hiking rates this year.

“The RBI is likely to hike the repo rate to close to 6 per cent by early next year. This will have some impact on the short end of the yield curve,” says Pathak.

He adds that the bond market, which has discounted a larger part of the rate hikes, is likely to be less sensitive hereafter to further hikes by the central bank.

According to Sen, “Most of the rate-hike cycle is already priced in. One can expect bond yields to move up by a small amount from current levels.”

YTMs of bond funds may hence improve slightly hereafter.

Stick to shorter-duration funds

With interest rates likely to rise further, investors should keep a larger part of their portfolio at the shorter end of the yield curve.

“To avoid MTM hits to your portfolio, stick to shorter-duration funds, like liquid funds and money-market funds,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.

According to Pathak, the longer end of the yield curve faces risk due to demand-supply mismatch (the government plans to sell around Rs 14 trillion worth of bonds this financial year).

Investors who want higher yields should buy and hold target maturity funds.

“The sweet spot here is funds maturing in four/five years,” says Raghaw.

You may also consider dynamic bond funds.

“They offer fund managers the flexibility to adjust the portfolio, much required in this environment,” says Pathak.

Avoid longer-duration funds.

“Once inflation begins to soften and the interest-rate cycle turns, that’s when you should enter longer-duration funds,” adds Sen.