The Reserve Bank of India (RBI) has increased the repo rate by 50 bps to 4.90%, governor Shaktikanta Das announced on Wednesday, in its fight to contain the soaring inflation. The rate hike comes after an off-cycle hike last month. The repo rate hike is broadly in line with the market expectation.

Churchil Bhatt, executive vice president and debt investments manager at Kotak Mahindra Life Insurance, expects rate hike by another 60 bps to 75 bps in FY23. The bond yield curve, says Pankaj Pathak, fund manager-fixed income, Quantum AMC, is already pricing for a repo rate of 6% by early next year. Thus, the bond market may not be too sensitive to RBI’s rate hikes going forward. However, high global monetary policy uncertainty, rising crude oil prices, and unfavourable demand-supply dynamics will continue to put upward pressure on medium to long-term bond yields.

Liquid funds to become attractive

While fund managers are confident of debt funds to provide much better accruals, at the same time, given the uncertainty on expected inflation, high fiscal and current account deficit, longer end of curve might continue to remain volatile. With this view in mind, it would be prudent to invest in shorter duration debt funds as accruals are decent and duration risk is contained.

From an investor's perspective, the return potential of liquid and debt funds has improved significantly after the sharp jump in bond yields over the last six months. Currently, liquid funds have given an average absolute returns of 1.80% in the last six months. In the last one year, these schemes have delivered 3.39% returns, shows data by ValueResearchOnline.

The interest rate on fixed deposits have also started to move up and are expected to move higher in the coming months. However, Pathak believes debt funds will become more attractive. "The gap between the bank savings rates and liquid fund returns will widen and remain attractive for your surplus funds," says Pathak.

Investors with a short holding period and low-risk appetite, he adds, should stick to categories like liquid funds of good credit quality portfolios. Medium- to long-term interest rates in the bond markets, as per Pathak, are already at long-term averages as compared to fixed deposits, which remain low.

Another category that is very well suited for current cycle is floating rate funds. Upward shifting of overnight rates bodes well for floating rate funds, says Akhil Mittal, senior fund manager, Tata Mutual Fund. "Constituent wise, floating rate bonds may benefit from rate hikes as accruals go up while effective duration remains very low. So high predictability and lower volatility could make floating rate funds a well-suited choice in current times.” Floating rate funds, in the last one year have delivered abysmal returns of 2.69%.

Pathak of Quantum AMC believes investors with more than 2-3 years holding period can consider dynamic bond funds which have the flexibility to change the portfolio positioning as per the evolving market conditions. These schemes, as defined by SEBI, can invest across duration. However, such investors should be ready to tolerate some intermittent volatility in the portfolio value.

Follow us on Facebook, X, YouTube, Instagram and WhatsApp to never miss an update from Fortune India. To buy a copy, visit Amazon.