The bond market is passing through a rough patch. Multiple shocks over last six months — sudden tightening by US Federal Reserve towards the end of 2021, spike in commodity prices due to geopolitical tensions, RBI’s sudden move to increase rates to check inflation and now fears of a recession — have triggered a sell-off in bond markets, pushing up yields. Here’s how debt investors can do well despite the bumpy ride.

Inflation to Ease?

Inflation has been at the core of this chaos. Retail inflation was above 7% for third month in a row in June. It had touched an eight-year-high of 7.79% in April. This is above RBI’s target of 4% (+- 2%). But central bank is hopeful. Governor Shaktikanta Das says inflation may ease gradually in second half of the financial year. “With supply outlook appearing favourable and several high-frequency indicators pointing to resilience of the recovery in first quarter (April-June) of FY23, our current assessment is that inflation may ease globally in second half of FY23,” says Das.

Commodity prices, major contributors to spike in inflation, have fallen considerably from April-May 2022 peak due to economic contraction and demand destruction. As of July 5, 2022, most metals were down 10-20% since the end of May, the peak of supply disruption due to war between Ukraine and Russia. Many agricultural commodities have dipped 5-20% during this period. From India’s perspective, the most notable is decline in crude oil, palm oil and wheat prices, which fell 14%, 37%, and 23%, respectively, in one month ended July 5, 2022. These were major contributors to domestic inflation. The drop should ease some inflationary concerns, says Pankaj Pathak, Fund Manager, Fixed Income, Quantum Mutual Fund. But he adds that this may not be enough to have any material impact on RBI’s policy direction and its pace yet. “For Indian bond market, local inflation and demand-supply dynamics will likely have a greater influence,” he says.

Anand Nevatia, Fund Manager, Trust Mutual Fund, expects RBI to increase the repo rate, currently 4.90%, by another 75-100 basis points by September this year. “We expect 10-year benchmark bond to trade in the range of 8.00-8.25% and overnight rates in the range of 5.50-6.00% by March 2023,” he adds. One basis point is hundredth of a percentage point. Ten-year government bond yield peaked at 7.60% on June 13 this year and fell to 7.45% by month-end. On July 6, it was at 7.30%.

Pathak of Quantum Mutual Fund says we may see another 35-50 basis points rate increase in August meeting of RBI’s monetary policy committee (MPC). He expects RBI to increase rates in remaining MPC meetings in 2022. However, the pace of rate hikes may slow down after central banks reverse their accommodative policies implemented during the pandemic, he says. “Overall, we expect repo rate to peak around 6% by early 2023.”

Rising interest rates make new bonds with coupons more attractive. As a result, existing or older bonds with lower coupons become less attractive and lose their value.

However, even if funds in your portfolio are making losses, it may not be the ideal time to sell.

Where to Invest

Yields have risen sharply over the last few months. This has hit returns from medium and long-term debt funds. Now that yields have risen considerably, redeeming these funds will be a mistake, says Rajiv Shastri, Director and CEO, NJ AMC.

Anitha Rangan, economist at Equirus, explains the positive side. As debt fund investors usually invest for three years to benefit from indexation of long-term capital gains, interest rates are likely to stabilise at the peak of the three-year cycle. “Investors can then get advantage of higher yields from these funds, ‘’ she adds.

Rajiv Shastri of NJ AMC says GSec yields appear to be already pricing in at least a 1-1.5% rate increase. Till markets expect increases within this range, yields will not rise further, something investors can take advantage of. “Risk-taking investors may consider locking in these yields now,” says Shastri. However, they must be mindful of wild swings during the period.

Investors may also make staggered allocations in roll down or target maturity portfolios of up to three years duration to prevent any significant mark to market impact. “High quality portfolios with up to three years are likely to yield 7%-plus, and with LTCG benefits, post-tax returns look attractive,” says Nevatia of Trust Mutual Fund.

For sophisticated investors, floating rate funds may be a good choice. Manish Banthia, Senior Fund Manager, ICICI Prudential AMC, says floating-rate bonds (FRBs) can outperform all other fixed-rate instruments and, hence, schemes with exposure to FRBs should be recommended when rates are rising. This is because they adjust coupons according to rise or fall in their benchmark or overall RBI rates. However, these funds may carry credit risk, and investors should do a thorough check before investing.

Pramod Sharma, Partner, Citrine Financial Services, says those looking to lock in their funds in long-term or dynamic schemes should do so in a staggered manner. “Use systematic transfer plan (STP) and invest over six to 12 months to lock in incrementally higher rates. This will protect you from rising interest rate risk to a great extent.” STP is a strategy under which an investor transfers a fixed amount from source scheme to target scheme. But new investors with a short horizon and low risk appetite will do better with categories like liquid funds, which gain from rising rates, says Pankaj Pathak.

Conservative investors may consider target maturity funds (TMFs) to earn more than bank fixed deposits. These are open-ended passively-managed funds that invest in components of the underlying index with a defined maturity. TMFs predominantly invest in government securities, PSU bonds and state development loans. They help you avoid interest rate risk if held till maturity. Also, there is negligible credit risk, as they invest in government and AAA-rated bonds. Some fund houses offer sovereign quality TMFs.

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