Stick to safer categories, select a fund mix that suits your risk profile

Avoid venturing into funds whose average maturity exceeds three-four years

The 10-year bond yield has hardened by about 15 basis points over the past month. When this happens, the net asset value (NAVs) of funds having higher average maturity heads south, and investors who have put their money in them experience losses. In light of this development, investors need to reassess their debt portfolio to ensure they are not in funds where they may see high volatility.

What has caused the spike?

Three factors have caused the spike in 10-year government bond yields. One, the central and state governments together intend to borrow a massive Rs 22 trillion from the markets this year. Around 60-65 per cent of this borrowing will be in longer-dated securities having a maturity of 9 years or more. “The heavy supply of longer-dated papers is expected to exert pressure at the higher end of the yield curve,” says Joseph Thomas, head of research, Emkay Wealth Management.

The Reserve Bank of India (RBI) chose to maintain the status quo in its last monetary policy review. In the past, when yields rose towards the 5.90 per cent mark, the RBI conducted open market operations (OMO) or Operation Twist. But it has not intervened in the market for more than a month now. “With the RBI not announcing an OMO programme, traders are shorting the market,” says Murthy Nagarajan, head-fixed income, Tata Mutual Fund. That has caused the 10-year G-Sec yield to inch up towards the 6 per cent level.

Consumer price index-based inflation came in at 6.93 per cent in July. The RBI indicated in its last review that it will not take further rate action until it sees substantial gains on the inflation front. Hence, further rate cuts could get delayed – to December or beyond.

Will yields harden further?

Experts don’t expect yields to harden much from current levels. “We don't expect a substantial jump in yields from the current levels, though small aberrations cannot be ruled out,” says Lakshmi Iyer, chief investment officer-debt and head of products, Kotak Mutual Fund.

Growth will be poor this financial year and may remain low thereafter as not enough fiscal stimulus has been provided to support the economy. “The RBI has stated it will stick to an accommodative monetary policy till growth comes back,” says Nagarajan. Further, of the Rs 22 trillion of government borrowing, the RBI is expected to absorb around Rs 4 trillion through OMOs or direct monetisation. Also, CPI is expected to decline in the second half of the financial year due to gradual ending of the lockdowns (which will result in improved supply of goods), expectation of a good monsoon, and a favourable base effect from September. Due to all these factors, government yields may soften in the latter half.

 

How should you build your portfolio?

Iyer suggests that retail investors should adopt a core and satellite approach while building their portfolios. In the core portfolio, which should constitute 75-80 per cent of their total debt fund portfolio, they should hold funds that are not subject to excess volatility due to either duration or credit risk. In the satellite portfolio, high net worth individuals (HNIs) who have the appetite may take some credit or duration risk in search of higher returns.

In their core portfolio, investors can largely avoid duration risk by selecting funds whose average maturity does not exceed three-four years. And they can avoid credit risk by selecting portfolios that are 80-90 per cent in triple-A rated papers. They should hold funds like banking and PSU funds, short-maturity corporate bond funds, and other shorter duration funds in their core portfolio.

Investors should match their investment horizon with the average maturity of the fund. If they need to park money for less than three months, they should put it in liquid funds and ultrashort duration bond funds. For a six-month to one-year period, they may use low-duration and money market funds. Any surplus that has to be invested for more than a year may be deployed in short-duration funds or banking and PSU funds.

Conservative investors should avoid funds that carry credit risk for now. “The upgrade to downgrade ratio in term of value is still at 1:6, which means that for every one upgrade there are six downgrades,” says Nagarajan.

As for mistakes to avoid, Iyer says, “Do not engage in driving while looking into the rear-view mirror.” In other words, do not invest in categories where returns have been good in the past. She favours selecting a mix of funds that suits your risk profile and sticking to it.