INDIVIDUALS SHOULD NOW consider investing in long-term debt mutual funds to seize the opportunity for capital appreciation. Once rates fall, the value of long-term bond funds such as dynamic bond funds and gilt funds increases, offering the potential for good returns.
The anticipated decline in gross market borrowings is positive for the bond markets, and the government bonds’ inclusion in the global bond index will open a new source of demand from foreign investors. These factors will enhance the flow to the debt segment and bolster investor confidence.
Bet on dynamic bond funds, gilt funds
The longer the duration of the bond fund, the more it will benefit from falling interest rates. Pankaj Pathak, senior fund manager, fixed income, Quantum Mutual Fund, says the favourable shift in demand-supply mix is driving the long duration bond yield lower. “Long-term bond funds tend to benefit in this kind of market environment. For investors, dynamic bonds are more suitable than most of the other long duration categories due to their flexibility to change portfolio positioning if market environment changes,” says Pathak.
The longer duration of these funds has had a multiplier effect, leading to mark-to-market gains and capital appreciation. Nirav Karkera, head, Research, Fisdom, says current trends suggest that bond yields are likely to decrease further, potentially leading to capital appreciation for investors. “In anticipation of declining interest rates later this year, investors can consider long-duration or gilt funds as preferred options as these funds are perceived as risk-free investments, enhancing their appeal further,” he explains.
Long-duration or gilt funds often offer higher coupon payments compared to shorter-duration bonds, bolstering investor income in a low-interest-rate environment. Furthermore, the higher duration of these funds amplifies their sensitivity to interest rate changes, making them more attractive as rates decline. So, the combination of locking in yields, potential capital appreciation, higher coupon payments and safety position long-duration or gilt funds as compelling options for investors anticipating falling interest rates.
Diversify across bond types
Diversification across bond types, sectors, and issuers is crucial for effectively spreading risk, especially in the current market environment. If one issuer faces financial stress and defaults, the losses can be offset by gains or stability in bonds from other issuers, thereby reducing the impact on the overall portfolio. By diversifying across sectors, investors can mitigate these sector-specific risks and ensure that their portfolio isn’t overly exposed to any single economic downturn.
Anil Rego, founder, Right Horizons, says diversification across bond types is crucial to spread risk effectively as it mitigates the impact of any single bond defaulting or sector underperforming, thereby enhancing portfolio stability. “Given the current economic uncertainties and varying performances across sectors, a diversified bond portfolio can better withstand market volatility and economic fluctuations,” he says.
Interest rate fluctuations also affect bonds in various ways. Long-term bonds are more sensitive to changes in interest rates than short-term bonds. By holding a mix of short, medium, and long-term bonds, investors can balance their portfolio’s sensitivity to interest rate changes, protecting against potential losses due to rate hikes.
Puneet Sharma, chief executive officer, Whitespace Alpha, an online investment platform, says a well-diversified bond portfolio will act as a buffer against market uncertainties, provide a more stable overall performance and allow investors to pursue their financial goals with greater confidence and reduced risk.
Factors to consider before investing
Since long-duration funds are highly sensitive to interest rate changes, these are best for long-term investors who can tolerate short-term volatility and hold positions without panicking. The returns are taxed at the investor’s marginal rate, impacting net returns, especially for those in higher tax brackets.