Central Banks across the world have increased interest rates to contain spiralling inflation fuelled by monetary and fiscal stimulus undertaken in the aftermath of the Covid crisis. The unwinding of this stimulus since last year, especially the monetary tightening is beginning to have an impact on inflation.
Inflation in India also went up in sync with the rest of the world and in a bid to tame inflation, the Reserve Bank of India (RBI) has raised the policy repo rate by 225 bps from 4% since May 2022 to 6.25% to 6.25% as of December 2022. Correspondingly, the bond yields have also risen across the curve with the 1-year T-bill yield rising by 250 bps to 6.90% from 4.40% in the last one year. Peak Inflation is behind us and inflation has begun to slow down with last inflation readings coming in below expectations. This may augur well for fixed income investors going forward as RBI is expected to pause the rate hiking cycle.
Bond yields have stabilised and given the expectations of an end of the rate hiking cycle both domestically and internationally, returns from fixed income may stabilise. The yield curve in India is flat and in US it is significantly inverted. This means that the market is expecting inflation to fall and rate cuts by central banks going ahead. A falling interest rate cycle may benefit fixed income investors by way of capital gains, in addition to accrual income.
Debt fund investors have not had a smooth ride over the last two years as rising yields dented the returns of bond funds. As we march towards a pause in rate hike followed eventually by rate cuts, debt fund investors may expect to have a better experience. The current levels of bond yields may offer a good opportunity for investing in fixed income funds.
As the spreads of AAA Corporate Bonds and SDL over government securities are currently tight, we would recommend investors to look at funds having duration of 3-5 years with predominant sovereign holdings as they may offer a better risk-reward currently. Target Maturity Funds with predominant allocation to G-Secs are ideal for investors who are looking for a relatively safer and liquid avenue to take advantage of the current prevailing yields.
Why consider Target Maturity Funds at this juncture? These funds have a defined maturity date. The asset allocation is pre-defined and they can invest in G-securities, PSU Bonds, Corporate Bonds and State Development Loans.
These funds are either designed as Exchange Traded Funds or Index Funds. They are passively managed with a roll down strategy in which bonds are held till maturity. As a result, the duration reduces with each passing year, mitigating the interest rate risk to some extent, but not entirely. So investors in this category may experience lower volatility. The coupons are reinvested in the existing underlying bonds or bonds of similar maturity and credit ratings. If the fund for instance has a maturity of 2028, it will invest in bonds which will mature in line with the maturity date of the scheme. If the investment is held for over three years, investors get the benefit of indexation on long term capital gains. Lastly, since they are open-ended, investors can redeem before maturity to meet any exigency. Thus, TMFs have all the ingredients which may make them an ideal investment opportunity at this juncture. Investors need to choose a TMF which matches their risk-appetite and investment horizon.
( The author is the Head – Fixed Income, PGIM India Mutual Fund.)