Avoid speculating in long-duration funds, invest with 5-year plus horizon

If you are unsure about where rates are headed over the next year, go for dynamic bond funds

From a low of 6.98 per cent on May 16, 2023, the 10-year Government of India Security (G-Sec) is trading at 7.22 per cent. However, news of the inclusion of G-Secs in the JP Morgan Emerging Market Bond Index has sparked optimism in bond markets. Their inclusion in other bond indices could boost prices further. Investors who wish to gain from this development, and the possibility of a decline in interest rates, should choose between long-duration bond funds and dynamic bond funds.

Bond funds: Why now?

The inclusion of Indian G-Secs in foreign indices could lead to more money flowing into the Indian bond markets. A report by Kotak Securities titled ‘Bond index inclusion: Positive move with added responsibility’ estimates that inflows might reach $30 billion over the next 18 months. “There are solid reasons to be positive on fixed income currently. Bond index inclusion could attract large inflows from foreign funds once crude and US yields take a breather,” says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund.

Fund managers are positive about bond yields coming down. “The rate hike cycle has ended in most parts of the world. The rate cut cycle may begin in 2024. We expect bond yields to fall significantly from the current levels over the next 12 months. The 10-year G-sec yield could dip to the 6.5-6.7 per cent range next year,” says Pathak. Declining bond yields lead to capital gains.

Long-duration option

Long-duration debt funds invest in very long-term bonds. Since these funds have high interest-rate sensitivity, they gain the most from falling rates. However, they could also suffer mark-to-market losses if rates rise.

The safe way to bet on long-duration funds is by having a long horizon of five years plus. Says Joydeep Sen, corporate trainer and author: “Invest for the long term in these funds instead of going for trading gains. Have an investment horizon that approximately matches the fund’s portfolio maturity.” He concedes that since Reserve Bank of India rate hikes are perhaps over, and there is a possibility of rate cuts next year, it is a good time to invest in these funds.

Nonetheless, downside risks exist. “The possibility of interest rates increasing is minimal and may at best be of 25-50 basis points. If this happens, returns could turn negative in the near term. Furthermore, rate cuts may not happen within a short span but may be spread over a long period,” says S Sridharan, founder & chief executive officer, Wallet Wealth.

Who should invest?

Long-term debt funds can be included in longer-term portfolios. “All investors can consider long-term debt as a part of their allocation to their debt portfolios. Retired people looking for better yields over the long term can lock in yields and receive consistent, periodic dividends. The allocation within the debt component can be 30 per cent to long term, 30 per cent to medium term, and 40 per cent to money market,” says Sridharan.

 “Long-term money may be distributed between long-maturity bond funds and target maturity funds,” says Sen.

Consider dynamic bond funds

Investors who do not have a view on interest rates and are not sure about the maturity of the bond funds they should invest in may opt for dynamic bond funds. There are no restrictions on fund managers within this category vis-a-vis the credit quality or the duration of the bonds they can invest in. They are free to design a portfolio based on their interest-rate outlook. Investors who don’t have a fixed time horizon but can remain invested for at least three years may go for them. “Investors don’t need to worry about interest-rate cycles in these funds as the fund manager takes care of them. In the current macroeconomic environment which is filled with uncertainty, dynamic bond funds make even more sense,” says Pathak.

Sen says that dynamic bond funds can be a good option provided the fund manager gets his calls right. Check the fund’s track record and the portfolio’s credit quality before investing.