We must gear up for an interest rate hike this year: Axis Mutual Fund

The interest rate cycle may have bottomed out, though it hasn’t yet started its northward climb. The challenge for debt fund managers is to protect the value of investments and find pockets that can generate extra returns, above inflation, says R Sivakumar, head-fixed income assets, Axis Mutual Fund. With over two decades of experience across asset classes, he speaks to Vatsala Kamat about his work, which appears to be cut out for the year ahead, and what investors should do with their debt funds. Excerpts.

US bond yields have risen, spooking all markets. What impact do you think will the move have on bonds and equity markets? 

The rise in US and global bond yields is the result of a combination of factors. First, there is greater expectation that the economic cycle is turning towards growth, leading to rising expectations on inflation and commodity prices. Second, some central banks such as the US Federal Reserve are indicating their comfort with a higher level of inflation. This is essentially to make up for the recent history of very low inflation, thus leading to higher bond yields. And lastly, greater focus on government spending through stimulus measures is leading to higher government bond issuance, which is also leading to higher yields.

These factors are all consistent with improving US and global growth and persistently easy liquidity. In such a situation, we expect a positive impact on macro-economic growth in emerging markets, including India. There could be some impact of rising US yields on global bond yields, though the direct impact is quite limited.

With interest rates paused after steep cuts, what challenges do fixed income fund managers face?

After good returns through the interest rate cut cycle, yields on bonds are now substantially below the inflation rate. This is especially true of AAA-rated bonds.

Now, we must gear up for a hike in interest rates, which could happen this year. In a rising interest rate environment, we must protect the value of investments, find pockets that can generate extra returns and, finally, transition to a portfolio that would deliver sustainable returns that are above inflation. This is quite different from managing debt funds when interest rates fall – making capital gains then is a priority.

Are rising interest rates bad news for debt portfolios?

It is true that higher duration bonds suffer mark-to-market losses. But this is not true of all bonds.

One needs to balance the impact of duration of the bond and reinvestment opportunity. If you have a very short tenure such as the money market bond in a rising rate environment, the coupon and maturity of the bonds get reinvested at higher yields. For instance, if your investment horizon is 12 months and you buy a three-month commercial paper, then the same paper needs to be reinvested three more times. This works well when rates rise.

But in longer term instruments (say, of five years), cash flows happen in the future and you may have only an annual or semi-annual coupon. Apart from mark-to-market risk, reinvestment opportunity is limited, too.

Besides, each time debt markets throw different challenges. This time, the overnight (shortest duration) rates are at 3 percent, the lowest since the global financial crisis. But the long duration bonds are higher at around 6 percent. This indicates expectation of normalization in the economy from COVID-19. So, the fund manager must find resilient pockets that can balance the portfolio and optimize returns as interest rates rise.

January saw net inflows into credit risk funds. Are investors gaining confidence again on the category? 

Yes, we have seen net inflows. The negative news around credit risk funds is over two years old now. Besides, the macroeconomic situation has improved, interest rates have fallen, policy is supportive of growth, liquidity is abundant and corporate results are getting better.

Also read: Explained in charts: How debt funds dealt with credit risks in 2020

Many of the previously stressed sectors such as real estate are recovering. Worries about downgrades are receding. In fact, credit risk has been the best performing sub-segment within fixed income over the last six months. A combination of all these factors is giving investors the confidence in this segment.

So how does an investor take a call on bonds? 

Investors should not worry. The fund manager has the task of rebalancing portfolios. And fund managers have already started adjusting to the new reality of a rising interest rate environment.

For example, in our short-term funds, we have cut the duration. Recently, our study of returns from equity and debt returns over the last 25 years showed that an index of government securities outperformed the Nifty during that period. So, the important thing for investors to remember is to allocate their money to various assets. Do not chase asset classes.

What is your secret sauce for consistent performance?

In fixed income portfolios, the challenge is the low volatility in securities and the high correlation between bonds. In other words, all bonds with a 10-year or seven-year maturity usually respond similarly to market events. This limits the ability of diversifying risk as is possible in equities that allow you to buy a basket of stocks across sectors and diversify risk.

When there are macroeconomic or policy led changes, and all instruments in a basket move in the same direction, how do you stay ahead of the market? That is the challenge for me. I like that challenge. So, outperformance depends on second degree anticipations and understanding the relationship between the larger macro environments and valuations.

In debt funds, we can beat the market only by knowing what is already priced in. This is my biggest learning over the last 20 odd years.

What is your view on bond markets for the next two years?

For most of the coming year, we expect the RBI to proceed on the process of policy normalization. Coming from a decade of low interest rate environment, we expect rates to go up. Beyond that, rate hikes are dependent on the state of the economy. With the fiscal policy focussed on sustained growth momentum, RBI could increase rates to keep them above the inflation rate. To some extent, bond markets anticipated this move. The yield curve is very steep, indicating that the market has priced in future rate increases. We expect the credit markets to do well while the economy is on the recovery track.