What if the Reserve Bank of India (RBI) raises interest rates? If 10-year government security (g-sec) yield is anything to go by, the rising interest rate regime is not far.The 10-year benchmark bond issued by the central government touched a peak of 6.95% on 4 February after the government announced its higher than expected borrowing programme for the financial year 2022-23 on the Budget 2022 day. The yield has moderated slightly to 6.79 per cent as on 9 February after the RBI called off a scheduled bond auction of ₹24,000 crore this week, but the bond market very much expects it to hit 7% over the next couple of months. Why should you be concerned about the g-sec yield?
Understand interest rate risk
You may feel that your debt instruments are safe, but they tend to be volatile due to interest rate risk. For example, if you are invested in a debt fund that has long-duration papers in it, your mark-to-market (MTM) losses - the fall in net asset value – would have increased after the 10 year g-sec yield rose. This is because bond prices and yields are inversely related.
A surge in yield causes bond prices to fall, thus causing a loss to your investment value. The MTM impact on your short-duration funds would have been meagre as the 5-year and lower g-sec yields have not wavered much. In fact, the term spread between one-year treasury bill versus 10-year treasury bill is about 2.2% (as on 9 February), which usually ranges between 1.5 and 1.7%.
“The steepness is so high that the spread between 10-year g-sec and five-year g-sec is the highest in history," said Nishant Batra, co-founder and Chief Goal Planner, Holistic Wealth.
It is to be noted that corporate bond spreads are near multi-year lows.
“It presents additional detrimental impact on prices when spreads revert to their long-term averages. Hence, at this juncture it is advisable to invest into funds with high exposure to g-sec," said Dhaval Kapadia, Director-Portfolio Specialist, Morningstar Investment Advisers.
Where to invest
There are 16 categories of debt funds based on different durations.
“It is better to play the start of the rising rate cycle with liquid funds because as and when the RBI increases the repo rate, the short-term money market yields will mirror the rise with low MTM risk," said Arvind Chari, Chief Investment Officer t Quantum Advisors India.
If you do want to capture the steepness at higher end of the yield curve, take the staggered approach, that is, ride the yield curve by doing multiple investments of small amount instead of lump-sum in medium to long duration debt funds.
“In initial few months, there may be an impact of MTM but as you ride down the yield curve the discount rate of calculating the bond prices and hence the net value asset (NAV) will start reflecting capital gains (apart from high accrual)," Batra suggests.
Kapadia advises a core and satellite approach if you have a time horizon of three to five years.
“The core allocation (~70-75%) should be invested into shorter duration high credit quality accrual funds (low duration, short-duration, target maturity funds / gilt index and medium duration funds) and the rest (~25-30%) to medium-to-long term funds, dynamic bond, gilt and credit risk funds," said Kapadia of Morningstar Investment Advisers.
“One could add a credit risk fund (~10-15%) to the portfolio when bond spreads over g-secs widen from current low levels," he added.
Keep it simple
Get the basics right. You invest in debt funds to maintain some liquidity and diversify your portfolio beyond equities. Earning a little higher than savings account or fixed deposits should be the goal. In any case, as interest rates rise, the savings account rates may not go up as early. “Consider liquid funds as an alternative to savings account for excess capital," suggests Chari.
“If you have a time horizon of 3 years+, then a combination of liquid fund and say a dynamic bond may work well over locking in at current rates in fixed deposits, provided you gradually increase your allocation to dynamic/long term bond funds on every rise in market yields in the coming year," says Chari. Besides, a simpler way to ride the yield curve is via target maturity funds in the rising interest rate regime.
“Rising interest rates will help in improving the returns as reinvestment income (from regular coupons from underlying securities) goes up," said Batra, suggesting Bharat Bond 2030 FOF and Edelweiss Nifty PSU Bond Plus SDL Index Fund 2027 in this category.
“If you invest before 31st March, you will get the extra indexation to lower down the tax outflow on maturity," he added.
The good old Fixed Deposits (FDs)
If you do not have a risk appetite for debt mutual funds, you can simply invest in fixed deposits, which may have lost favour over the last couple of years, but will turn attractive as the interest rates rise.
HDFC Bank and SBI have already hiked short-term FD rates by up to 10 bps. Refrain from locking money in longer duration FDs. Take the ladder approach instead.
For example, if you have ₹10 lakh, start ₹2 lakh FDs of different duration across one to five years. When one-year FD gets mature, you can again lock money for another five years. This way you will have an FD maturing after each year that can get reinvested at higher interest rate.
This will reduce the interest rate risk and gain the optimal risk-free returns on your investment.
