By Sandeep Yadav
Inflation is now among the hottest topics around the world as central banks globally are hiking rates ferociously to neutralise it. In India, the RBI has been indicating that inflation is manageable, has reached its peak and is likely to decline gradually to its comfort zone. It is possible, since the economies and dynamics, including the labour markets are different. However, the domestic market is pricing in higher-than-indicated hikes in coming months.
This is partly because the market believes that it is not completely out of the inflationary woods. On the other hand, Indian bond markets are looking to see our sovereign bonds included in the Global Bond Indices (this time, it seems more real), and want to benefit from gains. All this has driven volatility in bond markets and makes investing indeed a difficult task.
How does one invest in fixed income in such a time, especially when one feels the pinch of inflation far higher than the data, and the need for “real returns” is driving investors into riskier asset classes?
Let us briefly touch on a few factors influencing the market. One is the global central bank actions and their impact on the rupee, which may force RBI’s hand. Two is the demand-supply dynamics of bonds — while the market was gasping at how the large fiscal deficit will be absorbed, hope came in the form of bond inclusion in the global index, which could help absorb large fiscal borrowing.
To any investor, we suggest diversification keeping in mind risk appetite and the time horizon for investments. The worst would be to work with a “trader mentality” of trying to capture tops and bottoms and placing too much emphasis on near-term factors and momentum.
For starters, yields are prone to mean reversion. In recent history, 10-year yield has not been over 8% or below 6% for a long time. Currently, it is close to 7.4%. As we can see from what we said earlier, unless there is Bond Index inclusion, the yields are likely headed higher. This is what we call “an event risk” and it is hard to predict. We would therefore recommend that the investor invest either (i) in active funds to weather the event risks, or (ii) diversify with a mix of long and short duration funds.
Which active fund to choose? A gilt fund is a good choice as corporate spreads are quite low, and it may give better risk-reward.
How to diversify and where?
It all depends on the risk appetite and ability to stomach volatility. One can look at target maturity or roll down funds. Yields could probably fall in the next 2-3 years and an investment in 2025 maturity funds could mean the fund expiry yields may be low impacting reinvestment opportunities. Instead, one may prefer to lock in 2027-2028 maturity that traverses length of interest rate cycle—at expiry yields that may be higher and lucrative for reinvestment. Want greater yields and don’t mind the volatility? Take constant maturity funds like 10-year constant maturity funds. In this mix, use shorter maturity (less than six months) funds to earn accrual as you wait for volatility to play out — one is getting sufficiently rewarded for that as short-term rates are high (also known as flat yield curve).
This is the kind of market where you have too much (when yields rise) or too little (when yields fall). To paraphrase a popular song, “keep your eyes on the road and hands upon the wheel”. And, just don’t hit the accelerator or brakes too hard.
* Gilt fund is a good active fund choice as corporate spreads are low
* Lock in 2027-2028 target maturity funds that traverse the length of interest rate cycle
* Use shorter maturity funds to earn accrual
The writer is head, Fixed Income, DSP Investment Managers