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
Returns of different debt fund categories in the last one year
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.