At a time when the US Fed has cut interest rates by 50 basis points, domestic investors should increase exposure to long-duration bonds because of falling yields. Gilt and dynamic bond funds can take advantage of the potential capital appreciation as bond prices rise with falling yields, say experts.
Long-duration bonds will benefit the most in a declining rate environment. In fact, the Fed’s aggressive stance on easing rates, combined with India’s potential for rate cuts, creates a favourable environment for long-duration bonds.
Higher the duration, more the chances to earn bigger capital gains with a rate cut. In contrast, short-duration funds which are less volatile and offer stability will not see the same level of price gains because they are less affected by interest rate movements. Gilt funds, which invest in government securities, offer low credit risk and benefit from falling interest rates. Dynamic bond funds provide flexibility, allowing managers to adjust allocations based on rate changes, often increasing gilt exposure during expected rate cuts. Both of these long-duration bonds can offer stable returns and capital appreciation.
Maximise returns
Long-duration bonds often offer higher coupon payments compared to shorter-duration bonds, bolstering investor income in a low-interest-rate environment. The Fed’s aggressive stance on easing, combined with India’s potential for rate cuts, creates a favourable environment for long-duration bonds. So, if an investor aims to maximise returns post-rate cut, long-duration bonds offer better prospects for capital appreciation.
Nirav Karkera, head, Research, Fisdom, says as interest rates are expected to decline, bond prices will rise, particularly long-duration bonds, which are more sensitive to interest rate changes. “Investors can lock in attractive yields now and benefit from capital appreciation as bond prices increase when interest rates fall,” he says.
Similarly, Suresh Darak, founder & director, Bondbazaar, an online bond trading platform, says the Fed’s action is a pivot which is likely to boost flow of money to emerging markets and increase demand across asset classes. “It may lead to a rate cut cycle in India, which will result in demand and price escalation of long-duration bonds,” he adds.
Duration play
Long-duration funds are highly sensitive to interest rate changes. Individuals who can tolerate short-term volatility and hold the bonds for a long time should invest in these.
A balanced approach will be ideal while choosing the line of long duration investment in bonds at this stage. Jyoti Prakash Gadia, MD, Resurgent India, a financial advisory firm, says taking into account the various factors involved and the anticipated gradual approach of the Reserve Bank of India to cut rates, it will be prudent to have a mixed portfolio based on both five and 10-year duration bonds.
When investing in long-duration bonds, investors should consider key factors like interest rate sensitivity, as these bonds are highly affected by rate changes—rising rates lower bond prices, and falling rates boost them. The economic outlook is essential too, as central bank rate cuts during economic slowdowns can increase bond values.
Moreover, credit risk must be evaluated, favouring higher-quality issuers to minimize default risk. 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 in bonds from other issuers.
Investors should also keep inflation expectations in mind, as inflation reduces the real return on fixed payments. It will be wise to maintain some allocation to shorter-duration bonds or high-quality corporate bonds. “Such a strategy will bring stability and help to offset any risk related to the future interest rate changes or shift in economic conditions,” says Karkera.