The re-investment risk in fixed income is highly underrated. Across the board, the structural decline in interest rates of fixed income products like debt mutual funds, bank deposits, company deposits, NCDs, tax free bonds etc, in the last few years, has again highlighted this important aspect of fixed income investing. Fixed income instruments like debt mutual funds, company fixed deposit, NCDs, etc, have delivered around 8-10 per cent annualised return from 2018 to 2020. This return has turned lower in the range of 5.5-6.5 per cent now, as overall interest rates have declined. Investors are grappling with lower returns across debt products, and may find it difficult to achieve their planned financial goals.
To diversify, the overall portfolio should always make allocation to long-term maturity profile products (10-20 years) that do not get impacted by interest rate movement, and is in line with investment goals like retirement planning. Accordingly, long dated (20-30 year) government securities offer such allocation option. Currently, funds like Nippon Indian Nivesh Lakshya have buy and hold strategy for longer dated G-Sec and offer such allocation options. The average maturity of the fund is 23 years. It has low management expense and the yield is around 7 per cent. Investors who have a financial goal like retirement more than 10 years hence, may consider allocating some portion of their fixed income portfolio in this fund. An SIP over the next 1-2 years could be an ideal investment strategy.
Lock-in 7.03 per cent yield, manage interest rate cycle risk
Predictability of return is more important than 50-100 bps (basis points) higher return for a short period. While tactically, interest rate cycle may give opportunity to invest at higher levels, there are periods when interest rate cycles remain at lower levels, offering lower return across various fixed income products. For instance, 2018-2020 delivered higher return in debt mutual funds but it is likely that the same investor will now get lower return over next 1-2 years. While the rates have started to move up slowly, it still offers very low yield. The yield on the AAA-rated corporate bond funds are trading in the range of 5.5-6 per cent. The longer dated (around 10 years) tax free bonds are offering around 4.5 per cent return, while good quality AAA-rated corporate FDs are offering around 6.5 per cent for a 5-year period.
Therefore, it is important to allocate some portion of your fixed income in longer dated products that can lock-in coupon/interest rates and protect you from interest rate cycles. In other words, goal-based investing requires fixed income allocation to be made in products which have similar maturity profile as the financial goal. For instance, for retirement planning, we may want to allocate some portion in fixed coupon products for investment horizon of more than 10-15 years that takes away any interest rate risk or re-investment risk.
Debt market sell-off gives gradual entry opportunity to long-term passive investors
Indian debt markets have been under pressure since the start of calendar year 2021. Yields across debt market are gradually moving upwards after having rallied or moved down significantly since last three years. The yield curve is very steep, with yield from one-year government securities trading around 4per cent, 3-year at 5.25 per cent and 5-year at 5.7 per cent. The benchmark 10-year G-Sec yield is trading around 6.15 per cent levels, but the longer dated 30-year G-Sec is yielding around 7.05 per cent. In general, the outlook for debt markets remains cautious, and tactical investors better adopt a wait and watch approach until the market stabilises.
But for long-term passive investors who are not worried about near term mark-to-market losses, the steepness of the yield curve offering higher yield on higher duration papers, offers good gradual entry opportunity. While in general, long duration funds are considered for capital gains, steepness of the yield curve offer margin of safety to a certain extent from any potential capital loss as well. The major risk remains sharp reversal of rate cycle with RBI guiding to hike rates, which looks unlikely in the near term.
Goal based investing important in fixed income
Goal based investing requires matching the investment horizon with the maturity profile of a product. If an investor’s retirement is 20 years later, she should allocate some portion of her debt portfolio in funds or instruments which have 20 years of maturity, so that she does not have to worry about change in coupon/interest rates. This lends predictability in the portfolio, which is of great importance to peaceful wealth creation. Locking in coupon/interest rates is extremely important, as interest rates and cycles are dependent on many economic and other variables. The financial goal may not be achieved if the investment horizon does not match the maturity profile of the underlying investment product. One of the main reasons behind the success of PPF and EPF is that interest rates movement is not as wide as other unregulated fixed income options like bank FDs, debt mutual funds etc. Since PPF, EPF, etc, have restriction on the amount, some long term fixed coupon alterative is required to allocate for retirement corpus or any other long term financial goal.
For instance, someone doing 5-year fixed deposit in SBI since last many years and earning 8-9 per cent returns, is now getting only 5.4 per cent interest. In the current environment, investors are left to earn only 5.4 per cent for a 5-year period. Similarly, debt mutual fund YTMs or expected return was 8-9 per cent 2-3 years back, but is now closer to 5-6 per cent.
