Debt Funds Are The Way To Go Currently

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Debt Funds Are The Way To Go Currently
Investors should match the duration of their funds with their investment horizons
OLM Desk - 05 April 2023

With volatility ruling the market, fixed-income investing is gaining traction but what should be the strategy in a high interest rate environment?

As part of the second episode of the Master Talk series, presented by LSEG Group, one of the world’s largest providers of financial markets data, and Outlook Money, Deepak Agarwal, CIO of fixed income and head product at Kotak Mahindra Mutual Fund spoke about the challenges and opportunities in fixed-income securities in the current environment. The master talk was moderated by Suddhasattwa De, a sales specialist for London Stock Exchange Group (LSEG)’s South Asian Research and Portfolio Management division.

We are going through a period of high inflation globally. Where will the rates go in the future and how do you see the current interest rate scenario?

The Reserve Bank of India (RBI) has provided an average inflation target of 5.3 per cent and a terminal repo rate of 6.5 per cent. That’s an appropriate real rate, given that the growth expectation for the next year is 5.75-6 per cent.

However, in the course of the last 15 days, there are signals that the US Federal Reserve may raise rates. Therefore, RBI may also hike rates by 25 basis points in the next policy which is in April. Also, even if RBI does not increase the rates, liquidity will continue to be tight and put upward pressure on the entire interest rate.

Regarding cuts, we do not expect any cuts during the current calendar, but towards the end of the year, the Feb may pivot. We expect RBI to ease rates with a lag.

Government bonds across all maturities are trading above expected inflation and yield is in the 7.25 to 7.50 band. Given this, could debt funds be an attractive investment option?

The entire government securities (G-secs) curve, from one-year to 10-year G-secs, is in the band of 7.25-7.50 per cent and based on inflation numbers, it does make sense to invest in debt funds currently. Plus, the yields from most of the debt funds are higher by approximately 200 basis points as compared to March 2022. So yes, they are attractive in the current scenario.

We prefer the three-to-seven-year segment in terms of duration and most of our portfolio composition is keeping that segment in mind. Investors with an investment horizon of more than two years can look at investing in short- or medium-duration fund strategies now.

Mutual funds have also launched target maturity funds of 4-6-year maturities. Investors with appropriate time horizon in addition to short- and medium-duration strategies can look to invest in these.

What about dynamic bonds? Are they meant for the long term?

Dynamic funds basically offer the fund manager the flexibility to increase or decrease the duration of a fund based on his interest rate view. The manager strives to generate alpha by actively managing the duration of the fund. In this environment, we believe that for the next three-six months, we could see some upward movement in the curve due to tight liquidity and higher supply, but in the second half or the next 12-18 months, we expect the yield curve to come down due to the Fed pivot and expectation of rate cuts. Therefore, we believe that over the next 18 months to two years, you need to dynamically manage the duration of your portfolio. Our strategy in dynamic funds would be to gradually increase the duration of our portfolio over the course of time in case there is a spike in yields. Therefore, in the current interest rate environment, investors with over two years of investment horizon can look at dynamic funds.

What is the overall advice to investors in debt funds?

Investors should match the duration of their funds with their investment horizons. So in case you are looking to invest your funds for a period of two to three years, you could either consider a short- or medium-duration fund. Or you could look at dynamic funds where the fund manager appropriately increases or decreases the duration and tries to create an alpha for the investors.

There is merit for investors to add fixed-income allocation to their portfolios.

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