How to position your bond portfolio for higher interest rates

A diversified bond allocation can help investors tide through an environment of rising interest rates.

Positioning your bond portfolio for higher interest rates
It is important for bond investors to not only adjust their future return expectations lower given muted capital appreciation but also have a more diversified bond allocation to offset higher interest rates.

Bond yields continue to rise in 2022 with the 10-year benchmark Indian government bond (IGB) yield up about 100 bps and short-term yields up about 150-200 bps so far this year, as central banks continue to guide rate hike expectations higher to tackle record high levels of inflation.

The macroeconomic environment is a key factor to determine one’s bond strategy going ahead with growth/inflation framework the central starting point. We expect India’s economic growth to remain above its long-term trend in FY 2023, supported by a low base, rising fiscal spend and a broad-based economic recovery amid a revival in consumption and private capex.

However, CPI inflation is likely to remain closer to RBI’s upper-bound target of 6% in FY 2023 given the pass through of elevated commodity prices, persistent supply issues and pent-up demand. Overall, the above macro backdrop is likely to result in faster policy normalisation by the RBI and US Fed pushing interest rates and bond yields higher, with the 10-year IGB bond yield likely to trade above 7.50% over the next 6-12 months.

As an asset class, bonds’ positive drivers are counterbalanced by risks. Attractive yield premiums (i.e the spread between 10-year IGB and repo rate) which is close to peak levels indicating oversold conditions, is a key positive driver for bonds. In addition, Indian bonds’ real yields are higher than their Emerging Market (EM) peers. However, three factors for bonds remain unfavourable – 1) Weak fiscal dynamics over the medium-term, 2) Worsening government bond supply balance given high supply of government bonds amid waning RBI support and muted demand by institutional investors and 3) Rising inflationary pressures and faster normalisation of policy rates by the RBI and US Fed.

In our view, a diversified bond allocation can help investors tide through an environment of rising interest rates by having exposure to:

Short-maturity bonds: We like short-maturity bonds (1-4 years) as they are less price sensitive to a move higher in bond yields than medium and long-maturity bonds. Further, the sharp rise in short-term yields over the last year reflects market expectations of a rising interest rate trajectory with the 1-year Overnight Indexed Swap (OIS) spread, indicating the RBI is likely to raise policy rates by at least 150 bps over the next 12 months. Thus, an aggressive pricing of rate hikes provides investors the potential for reinvestments at higher levels.

Corporate bonds: Corporate bonds are more sensitive to changes in growth expectations and do well in the current environment of above trend growth. Also, they are lower on duration and less interest-rate sensitive. In our view, fundamentals remain constructive for corporate bonds given (i) a likely revival in the credit cycle amid above trend economic growth in 2022 and improving asset quality for financial entities; (ii) broad-based economic recovery and better corporate profitability resulting in a likely reduction in credit default risk and (iii) corporate bonds valuations appear inexpensive relative to government bonds. Within corporate bonds a tilt to high yield can help enhance returns, given inexpensive valuations of AA/A corporate bonds relative to AAA corporate bonds amid an improving corporate environment.

Selective bond strategies like (1) Target Maturity strategies of medium duration are likely to benefit from higher carry, lower interest rate risk and falling residual maturity, (2) Floating rate strategies that can help investors to offset inflation and duration risk and (3) Dynamic bond strategies that provide investors better accruals and help actively manage duration risk.

Hybrid strategies: A balanced portfolio with a mixture of equities and bonds can help bond investors in search of yield to move up the risk curve by taking some exposure to equities but with lower volatility compared to having a pure equity exposure.

Overall, the macro backdrop for bond investors is likely to remain challenging as bond yields trend higher. Thus, it is important for bond investors to not only adjust their future return expectations lower given muted capital appreciation but also have a more diversified bond allocation to offset higher interest rates.

(By Saurabh Jain, Managing Director & Head, Wealth Management, Standard Chartered Bank, India, and Vinay Joseph, Director & Head, Investment Products and Strategy, Standard Chartered Wealth, India)

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