Excessive allocation to long-term bonds will expose investors to high market risk in a rising rate environment and result in loss in portfolio value
By Pankaj Pathak
Over the next six months, we would expect the Reserve Bank of India (RBI) to reduce the excess liquidity in the banking system. We expect an increase in the reverse repo rate from 3.35% to 3.75%, a subtle move away from the accommodative stance to neutral and then to a gradual beginning of rate hikes.
Looking beyond macros
From the bond market’s perspective, it is time to look beyond the current macro developments and potential policy changes. The yield curve is currently steepest since the aftermath of the global financial crisis. This means there is very low yield/accrual at the short end of the yield curve while the longer end is still offering a fairly high yield in the current low-rate environment. For instance, the 30-year government bond is currently trading at 7.2%. It implies a yield spread of +320 basis points over the current Repo rate of 4% and +220 basis points over a ‘prospective’ Repo rate of 5%, which may possibly be attained by the end of next year.
On the surface, this looks like a great investment opportunity. However, excessive allocation to long-term bonds will expose investors to high market risk in a rising rate environment and could result in a considerable loss in portfolio value if things go the other way. Thus, it is critical to have a balanced and dynamic approach in building a fixed income portfolio.
In our opinion, the longer term bonds are attractively priced and have potential to gain over the medium to long term. Exposure to short-term bonds is a balancing position to lower the overall portfolio duration or sensitivity to interest rate changes. We have tried to avoid the intermediate maturity segment, which in our opinion is highly sensitive to change in policy direction and likely to be a poor performer in the next 6-12 months.
The economy and markets are currently adjusting to an unprecedented shock. Thus, any forecast about the future is susceptible to change based on policy responses from the government and the RBI and the changes in global markets.
The writer is fund manager, Fixed Income, Quantum Mutual Fund