Allocate 20-30% to long-duration debt funds, enter with 6 to 8 years period

Even when investing solely for capital gains, stay flexible and extend investment horizon if required

Financial markets are in a buoyant mood after the recent US Federal Reserve (Fed) meeting indicated three cuts in policy interest rates in 2024. This development has instilled a sense of optimism among market participants. The Fed’s signal comes after it hiked policy rates by 525 basis points to tame inflationary pressures. On its part, the Reserve Bank of India (RBI) has raised policy rates by 250 basis points in its recent rate-hike cycle. The US Fed’s impending rate cuts are expected to have an impact on the RBI’s actions and bond yields in India.  

“The rate trajectory in the US is downwards. It augurs well for Indian long-duration bonds. Bond market sentiment has definitely improved. Comfort on inflation should prompt the RBI to relax tight monetary conditions and there should be a scramble to lock into the high yields in the bond markets, which should in turn result in higher returns in long-duration funds (LDFs),” says Sandeep Bagla, chief executive officer (CEO), TRUST Mutual Fund.

What do these funds offer?

Most of these schemes invest primarily in high-quality bonds, such as government securities (G-Secs), ensuring minimal credit risk. “An investment in long-duration bond funds gives regular income as bonds pay interest annually. The larger attraction is the possibility of capital gains due to appreciation in bond prices,” says Bagla.

LDFs have given 7.59 per cent and 3.7 per cent returns over the past one and three years, respectively. The expectation of rising policy rates, which caused bond yields to increase, resulted in the muted performance of these schemes over the past three years.

The interest-rate impact

A fall in interest rates can push up the net asset values (NAVs) of these schemes, as the prices of bonds held in the portfolio tend to go up. Conversely, rising rates impact these funds’ NAVs negatively.

“Investing in LDFs helps an investor gain when the interest rate in the economy is softening as bond yields and prices are inversely related,” says Vikram Dalal, managing director, Synergee Capital Services.

Fillip from global index inclusion

Another positive trigger to the bond market in India has come from the inclusion of Indian G-Secs in a global index. If more indices include Indian G-Secs, then a significant amount of money would enter India over the next year or so, which would drive bond yields down. The yield of the India 10-year G-Sec has come down from 7.47 per cent on March 8, 2023, to 7.19 per cent (December 21).

Take limited exposure

Given their high duration, these schemes are exposed to higher interest-rate risk. Hence, investors need to be careful while investing in them. Either they should invest with a very long investment timeframe or they should enter at a time when interest rates are headed south.

“It is a very good time to invest in LDFs as the risk-reward trade-off is in the investor’s favour. However, investors with a short investment horizon can avoid these funds as they could be volatile in the short term,” says Bagla. According to him, investors may allocate 30 to 40 per cent of their debt fund portfolio to LDFs.

“LDFs are good for investors willing to stay invested with at least a six to eight years horizon. Such investors may allocate 20 to 30 per cent of their debt portfolios to these funds,” says Dalal.

LDFs (direct plans) are, on average, offering a portfolio yield to maturity (YTM) of around 7.2 per cent. Dalal suggests spreading out one’s investment. “Investors should ideally stagger their investments in LDFs over an 18- to 24-month period,” says Dalal.

LDFs may also be considered by investors keen to postpone their tax liability. Schemes employing roll-down strategies are best suited to the needs of such long-term investors in fixed income.

Investors hesitant to commit for the long term or wary of high interest-rate risk may consider shorter-duration funds focused on high-quality bonds. These debt funds will also gain from declining interest rates, though to a lesser extent.