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Floating rate funds & TMFs are good choices

Floating rate funds, target-date maturity funds can act as potential shock absorbers


What a VUCA (volatility, uncertainty, complexity, and ambiguity) world we are living in! Gold is on a sizzle, equities sometimes drizzle, and the fixed income is on a fizzle. War has led to oil go on a boil, leaving investor portfolios to do much more toil.

Bond yields the world over have been on a northward march in the last few months, especially with the relentless increase in inflation in the US. The US inflation is now at 8.5%, while the US 10-year government security (g-sec) yield is sub 3%. That is a negative real rate of over 5.5%!  We have seen the US Fed hike rates first time in over three years to combat the worst inflation in the US since the 1970s. As recent as December last year, the markets were discounting three rate hikes in the current year 2022. 

Now, we are staring at 7-8 rate hikes for this year. Talks of recession have picked up momentum in the US, which is also reflecting in the futures rate curve. World over, the excesses that were injected into the system as steroids are being pumped out—an attempt to get back to the pre-pandemic era. 

In India too, the Reserve Bank of India (RBI) has finally bitten the bullet towards a change in policy stance by being ‘less accommodative’ even as it kept the policy repo rate unchanged with a unanimous vote.  The central bank has managed this by introducing a new tool — standing deposit facility (SDF), currently fixed at 3.75% — as a means to manage liquidity more efficiently. Thus, we have seen a 40 basis points rise in overnight rates. 

Inflation in India has continued its upward journey. The March 2022 CPI has come in at 6.95%. The RBI has increased the CPI forecast from 4.5% to 5.7% for FY 2023. Also, the growth outlook has been lowered from 7.80% to 7.20% for FY 2023. 

This unambiguously articulates RBI’s preference to sequence inflation over growth in its priority list. This is in line with global central banks’ narrative as well.  The policy has clearly shifted gear from being dovish to a more hawkish guidance and undertone. The accommodative stance is now geared towards being withdrawn to ensure inflation remains within target. Markets will now start discounting rate hikes at the earliest.

What should investors do?

This is the key question on every investor’s mind given the likely upward trajectory of interest rates. We have long argued that fixed-income investors need to focus more on the carry-over potential capital gains this year. That view gets further entrenched as markets have started discounting rate hikes way ahead of the actual event. 

The current OIS (overnight index swap) curve is indicating that the repo rate which is at 4%, will have to be hiked by 150 bps over the next 12 months - a very extreme reaction to the RBI policy. Equally important to note is that H1 FY 23 will see 60% of the total government borrowing programme. How well the RBI (in the role of a merchant banker to the Indian government) navigates through this mammoth borrowing programme would be a key determinant to the direction of bond yields going forward. 

Hence, investors are better off with strategies like floating rate funds, target-date maturity funds, and/or dynamic bond funds. These categories could act as potential shock absorbers and try reducing the impact of volatility on the portfolio. For instance, floating-rate securities have a periodic reset of coupon rates. This helps in a rising rate scenario, as the coupon fixing tends to be higher, thereby enhancing overall portfolio yield. 

Likewise, target-date maturity funds are open-ended in nature, and investors get an option to choose their preferred maturity date. This also helps in mitigating interest rate risk to a large extent as the underlying securities are in and around the targeted maturity date. The underlying credit risk is also known as the index constituents are made available ahead of the fund launch. 

Dynamic bonds tend to oscillate durations in line with interest rate outlook. This category may be a tad volatile in the near term due to yield movements. However, it is a good category to have in your portfolio with a 3-year investment horizon. The proportion of how much of each category to own is also a function of the time horizon, and risk appetite one has. Staggering investments is also a good strategy to try reduce interest rate volatility. 

Finally, it is all about being disciplined investment decisions, and even more important sticking to your asset allocation in times of market disturbances.

Lakshmi Iyer, CIO (debt) & head products, Kotak Mahindra AMC.


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Updated: 20 Apr 2022, 06:30 AM IST
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