Despite softening of 10-year G-secs, time not ripe for taking duration bets

Heres why investors should remain predominantly in shorter-maturity funds

The 10-year government bond yield has softened from its 52-week high of 8.23 per cent to 7.81 per cent currently. Due to this, the three-month returns of long-term gilt funds (1.75 per cent) and long-duration funds (1.73 per cent) are looking better than those of other debt fund categories. 

A number of factors have contributed to the softening of the 10-year G-Sec yield. “The Reserve Bank of India (RBI) has resisted calls for interest rate hikes to defend the currency and has clarified that hikes will only be used for consumer price index (CPI) targeting. The CPI outlook remains benign for now. This has brought down the market’s forward interest rate expectations,” says Suyash Choudhary, head — fixed income, IDFC Mutual Fund.

To deal with the recent liquidity tightness, the RBI did open market operations (OMO) worth Rs 360 billion in October and has announced its intent to do another Rs 400 billion worth of OMOs in November. “The RBI’s bond purchases have played a large part in the softening of the 10-year G-Sec,” says Mahendra Jajoo, head of fixed income, Mirae Asset Global Investments.

The benchmark yield may not spike in the near term. “The consumer price index is expected to remain benign for the next two readings due to softer food prices,” says Choudhary. He adds calculations on core liquidity suggest the RBI may have to do another Rs 750 billion-Rs 1 trillion of OMOs between December and March to keep core liquidity in the range of 0.5-1 per cent of the net demand and time liability of banks. Hence, not much volatility is expected in the near term. 

Investors should, however, avoid taking a higher duration exposure in their portfolios yet. “8-8.25 per cent has emerged as a strong resistance level on the upside. But whether interest rates will fall further from here is uncertain. The US Federal Reserve will continue to hike rates. Crude oil prices and the currency pose risks. The fiscal deficit target may not be met. The inflation rate has declined due to softer food prices, but the core inflation rate remains high,” says Jajoo. According to him, the 10-year G-Sec yield could remain range-bound between 7.5 and 8 per cent in the near term.

Historically, the average difference between the 10-year G-Sec yield and the repo rate over the past five years has been 76 basis points, while currently it stands at 130 basis points. Going by the principle of reversion to mean, there is scope for the G-Sec yield to soften in the future.

Experts suggest investors should not make tactical allocations to different debt-fund categories on the basis of their recent performance. “The bulk of a fixed-income investor’s portfolio should go into products that run controlled duration and credit risk. Conservative investors should invest 80 per cent of their portfolio in very high credit quality (predominantly AAA) short-term funds having an average maturity of around two years. Allocation to duration funds and credit funds should not exceed 20 per cent. This 20 per cent should be put in active duration (dynamic bond) funds. As recent episodes have shown, the ability to hedge credit risk is minimal because of the market’s illiquid nature,” says Choudhary. He is of the view that investors should stick to this 80-20 allocation irrespective of which part of the interest-rate cycle we are in.

Jajoo, too, suggests keeping 75 per cent of the portfolio in short-term funds. According to him, these funds should comprise bonds having an average maturity of three years. “This is where you will get the best carry (accrual gain),” he says. Investors having the necessary risk appetite, he says, may start increasing their duration bets when the US Federal Reserve signals that it is done with rate hikes in this cycle.