Stagger entry into longer-duration funds over next six months: Experts

To stay safe, keep bulk of portfolio in shorter-duration or target maturity funds

The Reserve Bank of India (RBI) has hiked the repo rate by 190 basis points (bps) since May 2022. Increasingly, the view within the debt market is that we are approaching the peak of the current rate hike cycle. Investors are keen to know how they should structure their debt fund portfolios in this environment, and whether they should enter longer-duration funds.

The rate impact

It is better to stick to shorter-duration funds in a rising interest rate scenario. These funds hold bonds which mature faster. As interest rates rise, their portfolios invest in newer, higher-yielding bonds. Their average portfolio yield, and hence expected returns, improve. These funds also face lower mark-to-market impact.

The situation is the opposite in longer-duration funds. As interest rates rise, prices of longer-duration bonds fall more, so the net asset values (NAVs) of longer-duration funds take a bigger hit.

Over the past six months, liquid funds have given an average return of 4.4 per cent while long-duration funds have given 2.7 per cent and gilt funds, with 10-year constant duration, have fetched 3.2 per cent. 

Is a pause likely?

The US Federal Reserve (Fed) has expressed its determination to raise rates until it brings inflation under control. If inflation persists in India, the RBI too will have to raise rates -- both to control inflation and to prevent a large differential developing vis-à-vis rates in the US.  

Experts believe the repo rate may be raised by another 50 bps. Says Joydeep Sen, author and corporate trainer (debt): “In my view, there will be another rate hike of 25-35 bps on December 7. Thereafter, there may be another rate hike in February 2023, which would be the last. The terminal repo rate would be 6.25 per cent, or on the outer side, 6.5 per cent. There is likelihood of a pause after February 2023 as inflation is expected to ease next year, from April 2023 onwards.”

If large rate hikes in the US lead to a slowdown or recession, the Fed will be forced to reverse stance and cut rates to stimulate the economy. The RBI, too, will then follow suit. Longer-duration funds will outperform in such a scenario.

Maintain a conservative portfolio

When investing in debt funds, investors should prioritise safety over returns. They can achieve this by keeping the bulk of their portfolio in shorter-duration funds.

“At this point, it would be prudent to maintain an overall portfolio yield of two years. A relatively small portion of the portfolio could be invested at the longer end of the curve,” says Sandeep Bagla, chief executive officer, TRUST Mutual Fund. He warns that longer-duration funds could react negatively if inflation remains stubborn and rates continue to rise.

Match your investment horizon

If you remain invested in liquid funds and interest rates begin to drop, you will be left with low returns. But if you invest in a long-duration fund or a gilt fund and interest rates continue to climb, you could face mark-to-market losses.

A low-risk strategy at this juncture would be to match your investment horizon with the portfolio duration of funds. “If you have a non-specific but long-term investment horizon, look at funds in the three-to-five-year segment,” says Amol Joshi, founder, PlanRupee Investment Managers.

Sen agrees. “Pick funds with portfolio maturity matching your horizon. For instance, if you have a horizon of, say, three years, you need not get into liquid funds. You are safe in corporate bond funds, banking and PSU debt funds, and short-duration funds,” he says.

Target maturity funds with minimum three-year maturity may also be considered, provided you can hold them till maturity.

With no certainty on when the RBI will stop hiking rates, stagger your investments in longer-duration funds over the next six months. This will ensure you are not hurt much even if interest rates continue to climb.