Your Money: Fixed income investors need to look at liquid funds now

July 28, 2021 1:00 AM

The market witnessed a broad-based selling, seen across the maturity curve. Even the 10-year benchmark government bond, which was tightly held around 6% by the RBI, broke out of its shell.

In the face of large government bond supply, these actions have reduced volatility and induced an uneasy calm in the bond market.

By Pankaj Pathak

The interest rate has the power to make or break an economy. In the last two years, Reserve Bank of India has not just intervened across the maturity curve, it has guided the market expectations through open commentaries about the level of bond yields, the shape of the yield curve and also through tactical interventions in primary debt auctions. In the face of large government bond supply, these actions have reduced volatility and induced an uneasy calm in the bond market.

Market turbulence
The RBI-induced calm in the bond market has been broken in the past few weeks. Bond yields have moved up by 20-30 basis points. The market witnessed a broad-based selling, seen across the maturity curve. Even the 10-year benchmark government bond, which was tightly held around 6% by the RBI, broke out of its shell.

In the short run, RBI’s actions will remain the key driver for the Indian bond market. The central bank has already committed to purchase `1.2 trillion of government bonds under GSAP 2.0 in Q2 FY22.Given the extraordinarily large size of the government’s borrowing requirement, RBI will have to continue its market interventions well into the future to maintain calm in financial markets. It is expected the RBI will buy Rs 4.0-4.5 trillion of central and state government bonds in FY22. This should extend some support to the market. However, we expect the RBI will continue to lower its other tactical market interventions like auction cancellations, devolvement, special OMOs, etc., and will allow market forces to adjust to economic reality.

Over the medium term, inflation and potential monetary policy normalisation will play a more important role in shaping the interest rate trajectory. With gradual progress in vaccination and inflation picking up, talks of policy normalisation will intensify. We believe bond yields have already bottomed out and expect it to move higher over the next 1-2 years.

What should fixed income investors do?
Investors should acknowledge that the best of the bond market rally is now behind us. At this time, it would be prudent to lower the return expectations from fixed income products—fixed deposits rates will remain low and potential capital gains from long bond funds will be muted.

Conservative investors should remain invested in categories like liquid funds where the impact of interest rate rise would be favourable. However, while selecting a liquid fund be cautious of the credit quality and liquidity of the underlying portfolio.

At this point where fixed deposit rates have come down to historical lows, liquid funds could be an option (with market risk) in comparison to locking in long-term fixed deposits. Liquid funds invest in up to 91-day maturity debt securities, which get re-priced higher when interest rates rise. Fixed deposits interest rates remain fixed for the entire tenor thus losing out during a rising interest rate cycle.

Investors with a higher risk appetite and longer holding period can consider dynamic bond funds where the fund manager has the flexibility to change the portfolio when the market view changes. These funds are best suited for long-term fixed income allocation goals. However, do remember that bond funds are not fixed deposits, and their returns could be highly volatile and even negative in a short period.

The writer is fund manager, Fixed Income, Quantum Mutual Fund

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