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How you can play debt funds to gain even from rising interest rates

Increasing allocation to floating rate instruments and investing in a simple roll-down strategy with a target maturity in mind are good ideas

September 29, 2021 / 10:04 AM IST

A rise in interest rates or yields means that the future investment returns for investors will also increase. Thus, they stand to gain in a rising rate environment.

Time in markets is more important than timing the market. This adage holds true for every asset class.  Markets go through different cycles and investors should stick to their asset allocation in every market cycle to obtain optimum results.

In response to the pandemic, monetary policy across the world has been ultra-loose and now there are expectations that it would get normalised, including in India. Investors can take advantage of the expected normalisation of the monetary policy by reshuffling their fixed-income investments. They could allocate more to actively managed funds and also look at some strategies specific to the current and expected interest rate cycle.

Pockets of opportunity still available

Unlike the previous cycles of reversal in interest rates, RBI will be very slow and gradual in normalising monetary policy. RBI has held that the recent bout of high inflation is due to supply side factors and that it will be calibrated in its actions. The dovish stance of the RBI and abundant liquidity have resulted in a very steep curve with one-year CD yields at 3.75 percent and five-year AAA yields being close to 6 percent. Thus the 4-5-year and longer part of the curve are factoring in not only normalisation of policy rates, but also monetary tightening in the next couple of years.

Close

Given the higher volatility at the longer end of the curve, investors should allocate more to the very short end of the curve, which is up to six months. They can also consider the 4-6-year part of the curve, which means investing at the two ends of the curve.  Investors can also increase their allocation to actively managed funds, which are able to take advantage of the dislocations in the yield curve.

Floating rate funds or target-maturity funds?

There are other strategies that can help investors take advantage of the expected rise in yields. These include increasing allocation to floating rate instruments or investing in a plain-vanilla roll-down strategy with a target maturity in mind. So, an investor invests at a point in the curve, which is relatively attractive from a risk-reward perspective and then holds the investment till maturity.

Systematic investment can also work in debt in a rising rate environment, as investors will keep pumping funds gradually at higher yields over a period of time. Investors can also consider a ladder investment strategy.

A ladder structure typically invests equally across the curve, with a target maturity in mind. The maturity amount every year is reinvested at the target maturity year, at a higher yield, assuming yields do rise. The investment pattern is structured evenly till the target maturity. In a ladder structure, assuming a maturity target of five years, the investment will be spread in equal proportion in 1-year /2-year /3-year /4-year/5-year segments, which means 20 percent every year.

The advantage of such a structure in a rising rate environment is that a part of the corpus that matures every year will get reinvested at a higher yield at the maturity point of the structure. Thus, in a ladder structure after one year, the bond maturing next year will get reinvested in a 2026 maturity bond (which will presumably happen at a higher rate, given the expectations of rise in rates). Thus, the yield of the portfolio will continue to increase till maturity (assuming the reinvestment happens at a higher rate).
Puneet Pal is Deputy Head-Fixed Income, PGIM India Mutual Fund
first published: Sep 29, 2021 10:04 am

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