Be mindful of risk appetite and the holding period when reviewing your investments.
The immediate action by the Reserve Bank of India (RBI) to contain the spike in yields in August, besides its efforts to maintain adequate liquidity, signals that yields may not move up significantly despite the pressure. However, the period of easy gains in debt markets may also be over. Is this situation a cue for investors to relook at their debt fund portfolios?
“While the sluggish economy and higher inflation numbers are matters of concern, the signalling actions of RBI on managing yields and liquidity in the banking system, combined with global interest rates being close to zero or negative, will have a positive impact on bond yields," said Lakshmi Iyer, head, fixed income, Kotak Mahindra Asset Management Ltd.
When yields are up, bond prices go down, reducing the net asset value (NAV) of debt funds. The longer the tenor of the securities, higher will be the impact on price. For example, funds that were affected the most by the yield spike in August were the ones that held longer-tenor securities. Returns from low-duration, ultra short-duration and money market categories were lower as compared to earlier months but not in the negative territory. “Investors should be clear about their objectives. Is it upfront gratification from capital gains, or substituting the banking fixed deposit or the savings bank account? Fixed income markets have opportunities for all these needs," said Iyer.
While a wholesale change in debt fund strategy may not be needed, it may be time to dial back the exuberance and lean towards conservatism in the safe portion of the portfolio. Here’s how you can do it.
Strengthen your core
The core portfolio is meant for asset allocation needs and must reflect the needs of long-term goals. Keep your needs and investment period in mind while choosing funds.
Choice of funds: Corporate bond, banking and PSU and short-duration categories are best suited for the core portfolio. Categories like medium-duration may also be suitable for investors willing to take on greater risks of interim volatility.
“Corporate bond funds with AAA and good quality AA portfolios with medium duration of three-four years can be considered even in this kind of market scenario," said Renu Maheshwari, CEO, Finscholarz Wealth Managers LLP.
For goals that are nearer, moving into fund categories that maintain lower duration portfolios may be a good idea to protect the corpus.
Choice of strategy: Investors who like predictability of returns may consider funds that follow a roll-down strategy that helps lock in the yield at the time of investing, but comes with a prescribed holding period. However, the strategy does not shield the portfolio from interim volatility. The Bharat Bond ETF series and open-ended debt funds that follow the strategy but invest in opportunities beyond PSU bonds are options to consider.
Also, the strategy excludes the investor from benefiting from interim yield softening. That may be seen as a drawback considering that the interest rate journey going forward won’t be unidirectional.
Iyer feels that funds with a roll-down strategy make a good add-on proposition to a debt portfolio but not as a core strategy given the prevailing low yields. “We are not calling it a day for interest rates yet. In a block of three years, if you have the potential for capital gains in the first 12-18 months and the next period may probably be for carry (yield earned). Open-ended funds that are actively managed allow for the best of both worlds which may not be possible in a roll-down strategy," she said.
“Investors should expect some volatility, but for three-four years holding period, short-term volatility should not matter," said Deepali Sen, partner, Srujan Financial Advisors LLP. Funds that follow dynamic investment strategy—repositioning the portfolio to reflect the interest rate view—can also help protect debt portfolios in a rising interest rate scenario. “Dynamic funds today are the best bet. They offer participation across duration and corporate bonds. They make agile movements to benefit investors," said Iyer.
While some funds have done very well in the past one year by moving into long-term gilts, the track record of the category itself in a rising interest rate scenario has been patchy at best. “Dynamic funds have done well in this cycle but in the past they have failed to capitalize on interest rate movements," said Maheshwari. “We are using these funds with caution this time around," she added.
“This strategy is a little opaque and investors have to take a chance with the fund manager’s ability to make the right calls on rate direction," said Sen, explaining why she does not favour this strategy.
Stay high on liquidity
For the portion of the portfolio where liquidity and capital protection is a priority, it is best to stay with overnight and liquid funds.
Rising short-term yields may not be an immediate concern given the high liquidity in the system. But if yields rise, funds that hold very short-term papers benefit as they are able to reinvest the maturity proceeds at higher yields as compared to funds that hold long-tenor papers whose maturities are farther away. Also, these funds see negligible impact on their NAVs from rising yields.
“All my clients’ funds required for immediate needs, including the emergency fund, are now held in liquid funds. Even money that was earlier held in categories like ultra-short," said Sen. Investors who were able to earn better returns on their short-term money in the rate reduction phase in categories that maintain slightly higher duration like money market, low-duration and even ultra-short should consider being conservative. In a rising yield scenario, these categories may see brief periods of negative returns.
For investors looking for tactical gains, there may not be as many low-hanging opportunities going forward as there were last year. A spike in yields will give opportunities to lock into higher yields.
“The bond story is not over yet. There will be pockets that will do well and that is true for all asset classes, and fixed income is no exception," said Iyer.
Gilt funds that were at the forefront of short-term returns may not be able to give a repeat performance. But those who remain invested for at least five years will see a reasonable return but with heightened interim volatility. “We had moved money into gilts as a tactical call in March this year. Our investors made good returns and we have, for the most part, exited this call now," said Maheswari.
Investors need to be mindful of their risk appetite and the investment period for a debt portfolio to plays its role efficiently. For the most part, investors should factor in returns normalizing in their debt portfolio going forward in comparison to the bumper returns of last year and moderate their return expectations. Higher returns will come only with greater risk. Given the uncertainty on economic recovery, it is important to keep a close eye on the credit risks in debt fund portfolios.