Fixed-income investors should opt for short, medium-term bonds: Here is why

Rally in the bond market primarily due to expectations of further hikes by the Fed

Fixed income investors should consider short and medium-term investment grade bonds with yields above 8% in the current market environment, according to the wealth management and advisory arm of Emkay Global Financial Services.

A short term bond fund is a debt mutual fund that normally invests in short term debt instruments with a maturity of up to 3 years. These funds will typically invest in Certificates of Deposit (CD), Commercial Paper (CP) and government securities with a residual maturity of less than 3 years. Of course, 

A medium term fund sits between short-term and long-term debt funds. Its underlying duration has to be around 3-4 years. If you have a similar time frame, a medium-term bond fund is meant for you. Historically, these funds also hold some securities with slightly lesser-rated securities.

 

Such bonds are suitable when the interest rates in the economy are expected to stay stable ot move down. They can also  be a worthy replacement of medium-to-long-term Fixed Deposits (i.e., for an investment horizon of at least 3 years)

Short-term funds have a slightly longer duration than liquid funds, while medium-term funds have a longer investment tenure. Medium-term funds, on the other hand, can help you preserve your capital and earn interest in the process, while simultaneously proving to be useful for goals with a longer due date.Rising interest rates reduce the prices of bonds, while falling rates drive the prices of bonds up. Now, the longer a bond or a fund’s tenure is, the longer it is exposed to risks from changing interest rates. So, while liquid funds may have negligible interest rate risk owing to their extremely short tenures, short-term debts funds have a slightly higher risk in this regard. And medium-term funds have an even higher interest rate risk. 

"Additionally, there are longer-duration credit products offered by mutual funds and non-mutual fund entities, providing higher effective returns over the life of the products. However, any exposure to such products should be carefully chosen based on the track record of the managers of the products as also the periodic cash flows expected from the investment," advised Emkay Wealth Management.

Now, bond prices and interest rates have an inverse relationship, so  an increase in interest rates negatively affects the bond prices. When interest rates rise, bonds offering lower returns become less attractive, which results in nvestors opting for higher-yielding instruments.

This causes the bonds’ market prices to fall, bringing yields close to other instruments. RBI has paused the interest rate hikes since the last two policy reviews. Fund managers are of the view that the interest rate is near its peak and it may go down in the future. 

The Reserve Bank of India (RBI) has kept the repo rate on hold for the second time this year. "This may continue for a longer period if certain factors do not disrupt the equilibrium. The two critical factors that may influence the central bank's decision are the trajectory of retail inflation and the Dollar-Rupee exchange rate. Although inflation expectations are moderating, rising oil prices and essential commodities present a challenge. The RBI considers these factors important, if high prices persist, a policy reconsideration might be warranted," said Emkay Wealth management. 
 

The market has remained range-bound with no major movements either way in market yields. The recent improvement in system liquidity conditions and stable yields in the market has been influenced by factors such as the withdrawal of Rs 2000 notes, net inflows from overseas markets, and the RBI's pause in the rate hike cycle. Nevertheless, challenges remain, particularly in managing inflation expectations and the exchange rate. As a result, yields have stabilized in a broad range, with overnight rates ranging between 6.30-6.50% and one to three months money market rates hovering around 7-7.15%.

The domestic market has shown movements mirroring overseas markets, particularly in bond yields. "The long-end bond yields are likely to continue responding to overseas market trends until the interest policy aligns more closely with the optimal growth-inflation trade-off," the note said. 

 The US Federal Reserve's aggressive stance toward controlling inflation has led to expectations of further hikes, prompting a bond market rally upon the final rate hike. These movements are expected to continue until there is greater certainty about future price levels and policy decisions.

Approximately one-third of the government borrowing program has been completed. "To ensure the remaining half-year borrowing and the overall annual borrowing process do not impact money market rates adversely, liquidity enhancement measures will be required for relatively large issuances. An encouraging factor is an increase in tax collections, which, if sustained, may reduce the need to borrow more than budgeted by year-end," said the note.