This year RBI has been on a trajectory of tightening interest rates in an effort to control inflation. Repo rate has been raised three times. Repo rate hikes by the RBI raise bond yields, cause bond prices to fall and results in lower returns, especially for long term debt mutual funds. Surprisingly, RBI did not increase the repo rate in their October monetary policy meeting despite the US Federal Reserve hiking the Fed Funds rate in September. The 10 year Government Bond yield has moderated slightly from 8.2% to 7.8%. Long duration funds and Gilt Funds were the best performing debt mutual funds in the last 1 month; these two fund categories, on the other hand, were the worst performing debt fund categories in the last 1 year. In this article, we will discuss debt fund investment strategy in the current economic situation in India.

History of RBI interest rate actions

The chart below shows the history of RBI repo rate actions over the last 5 years. You can see in the chart below that repo rate peaked in January 2014 and since then RBI had been bringing down interest rate till August 2017. From August 2017 to June 2018, RBI maintained status quo on interest rates and then in the next two monetary policy meetings hiked the repo rate twice, each time by 25 bps. Surprisingly in the October meeting, RBI held repo rate at 6.5%, when the market was expecting a rate hike to arrest INR (Indian Rupee) depreciation.

Source: RBI

Let us now see what RBI rate actions did to the benchmark 10 year G-Sec (Government of India bond) yield in the last 5 years. You can see that the 10 year G-Sec yield was declining from April 2014 to July 2017. This was a great phase for long term debt mutual funds investors; many investors got double digit returns. Since August 2017, bond yields have been rising and this has caused long term debt fund returns to be disappointing for investors.


Returns of different debt fund categories in the last one year

The chart below shows the returns of different debt fund categories in the last one year. You can see that shorter duration funds clearly outperformed longer duration funds. This shows that the shorter end of the yield curve presents better investment opportunities in the current interest rate environment. Please note that we are showing category average returns; individual debt mutual fund schemes may have outperformed or under performed the category returns.

Source: Advisorkhoj
What should your fixed income strategy be?

When outlook on bond yields is uncertain, with rising short term yields the best strategy in the near to medium term is accrual. In an accrual strategy, you hold short duration or very short duration bonds or money market instruments till maturity. In this strategy, you will earn the interest (coupon) paid by the bond and bond price changes will not affect your returns because by holding the bond to maturity, you will get the face value (price changes in the interim will be irrelevant).

The chart below shows the India yield curve and its shifts in the last 6 months. You can see that the yield curve has shifted upwards more towards the short end compared to the longer end in the last 6 months. From a risk return perspective therefore, it makes more sense to invest in shorter end of the curve because you will get better returns relative to risk taken by investing in the longer end of the curve.

As such, in our view, for investors with shorter investment tenors (less than 3 years), it is better to invest in shorter duration funds compared to longer duration funds. You can invest in liquid funds, ultra short duration funds, money market funds, low duration funds, short duration funds etc, depending on your risk appetite. To get higher yields you can also invest in corporate bond funds or credit risk funds, but you should be clear about the risk factors before investing.
source: Advisorkhoj

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