With yields hardening, its best to opt for shorter-duration funds

Shorter-maturity bonds in these funds get reinvested at higher coupon rates

On Monday (October 11), the 10-year government bond yield closed at 6.35 per cent, a level it had touched 18 months earlier (on April 17, 2020). As yields rose, the net asset values of many longer-duration bond funds registered decline.

End of assured bond-buying

The immediate reason for the spike in yields was the Reserve Bank of India’s (RBI's) policy announcement discontinuing its G-Sec Acquisition Programme (G-SAP).

“The absence of assured bond purchase in this quarter has created pressure at the longer end of the yield curve,” says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund. The discontinuation of G-SAP took the market by surprise.

“Market participants expected the RBI to reduce G-SAP. Instead, it chose to discontinue it. This caused yields to shoot up,” says Joydeep Sen, corporate trainer and author.

The impact has been muted at the shorter end.

According to Pathak, “There is a high surplus of core liquidity. The RBI is currently reluctant to employ any tool that can absorb liquidity on a durable basis. In the absence of such measures, the short-end will remain supported.”

The macroeconomic backdrop has also changed. On the global front, the US Federal Reserve has turned more hawkish. In its latest policy, it announced that quantitative easing (QE) tapering would begin from November this year and end by mid-2022.

“This is a fast-paced reduction in the QE programme,” says Pathak.

Brent crude also closed above $84 per barrel on Monday. Indian bonds have a strong correlation with the price of crude oil.  

Will yields continue to harden?

Market participants are of the view that interest rates have bottomed out and the cycle is about to turn. They expect systemic liquidity to be reduced first. During the Covid-19 pandemic, RBI Governor Shaktikanta Das had taken the emergency measure of reducing the reverse repo rate. The corridor of 65 basis points, or bps (the difference between the repo and the reverse repo rate) is likely to be reduced to 25 bps gradually. A small hike in the reverse repo rate may occur as early as December. The repo rate hike may come later.

Yields in the secondary market may move up gradually in response to the RBI’s measures and other signals.

“Yields are likely to move up more at the shorter end, because the shorter end had rallied more. The rise is likely to be less at the longer end,” says Sen.

What you should do

Longer-duration debt funds have a longer modified duration, which makes them more volatile.

“An investor with a very long investment horizon of, say, 10 years, should continue to hold on to gilt and other longer-duration funds,” says Sen.

Investors with shorter investment horizons may avoid them.

“As interest rates rise, the portfolio value of these funds will register a decline,” says Harshad Chetanwala, co-founder, MyWealthGrowth.

The bulk of an investor's portfolio should currently be in shorter-duration funds. Select the exact category by matching your investment horizon to the portfolio duration: overnight funds for an investment horizon of one day, liquid funds for up to three months, ultrashort duration funds for three-six months, low duration and money market funds for six-12 months, and short-duration funds, banking and public-sector undertaking debt funds and corporate bond funds for two-three years.

Investors may also opt for dynamic bond funds.

“Both the economy and the monetary policy are in transition. Dynamic bond funds give their managers the flexibility to change their portfolios in response to the changing environment,” says Pathak.

Chetanwala suggests that even when selecting shorter-duration funds, investors should pay heed to the portfolio’s credit quality. Target maturity funds are another good option in a rising rate environment for inve­stors with a medium- to long-term horizon.