If you are investing in fixed income for the long term as an asset allocation strategy, you may continue to buy long-term funds even in rising rate environment.
For most retail investors, fixed income investing is Greek. Many times it’s the highest yield which is the winner or the easiest available option such as bank fixed deposits (FDs) , NSC, etc., or just continuity. In a scenario of worsening macroeconomic environment, rising rates and high uncertainty investors do look back and reflect on their strategy.
Typically, FDs have formed a larger part of fixed income allocation. Retail investors nonchalantly bear a FD’s costly liquidity risk in form of lower premature withdrawal rates/ penalties in exchange of perceived safety as FDs are not subject to mark-to-market (MTM) risk. In the last two to three years, cleaning of NPAs has meant a slower credit growth and in turn reflecting FD rates not in synchronisation with prevailing market rates.
Debt funds, being capital market driven, reflect the interest rate changes without any delays on being MTM. Most of the time, running yield of the fund is higher than the FD rates of the same duration bucket. Also, debt funds offer better post tax returns for a 3-year holding period.
Risks in fixed income
An investor has to be aware of the three main type of risks to earn a superior return through a fixed income offering—liquidity risk, duration risk and credit risk. The credit risk depends on individual appetite and it can be gauged from rating profile of the fund’s holdings. Generally, in times of rising rates, credit risk increases as refinancing for weaker firms becomes difficult. Investors nearing their specific financial goal may immunise themselves by matching their cash flow timing with that of payout of the scheme.
For example, if you have achieved a good return on equity investments and your financial goal is to have a target corpus in next three years you may look to invest in three-year FMP to have better tax adjusted target return vis-a-vis other options. Here you have participated in all three risks mentioned above but your investment goal permits it. Rising rates don’t matter that much here due to tax efficiency and known holding period.
If you are investing in fixed income for the long term as an asset allocation strategy, you may continue to buy long-term funds even in rising rate environment. However, do this thorough systematic investment plan to take advantage of rupee cost averaging as in equity scheme.
For retail investors who have only a vague idea about their expected holding periods, one thing is sure. In this environment of rising interest rates, we have to shift to shorter maturity funds which capture best available yield commensurate to the expected holding period. In line with new Sebi classification, these are liquid funds (up to 3 month durations) ultra short funds (3-6 months duration), low duration funds (6m-12m duration), money market fund (up to 1 year duration).
Although credit risk funds have higher yields and should perform better in rising rate environment, they usually have to maintain at least 2-3 years duration to capture the credit spreads, making them more volatile and thus expected holding periods should be longer for investors here for better return expectations.
In case you have needs similar to both kind of investors described above, then you can implement both strategies and you would have implemented a kind of modified barbell bond strategy. Here you would have benefits of SIP in rising rates environment and less volatile short-term investments to protect portfolio value. These short-term investments can be liquidated at no cost to be redeployed again at higher rate in longer maturity funds.
By- Siddharth Chaudhary, The writer is fund manager, Debt, Sundaram Mutual