Here’s the fixed income portfolio that can tackle rising interest rates
3 min read 21 Mar 2023, 11:54 PM ISTEach time yield spikes, there will be some mark-to-market losses on a fixed income portfolio
PremiumInvesting in fixed income has never been so tricky. After a period of muted returns, fixed income investors are offered higher bond yields, but investors are faced with a fundamental question—is it the right time to build a fixed-income portfolio? What if bond yields go up further?
A key element we need to understand regarding the fixed income market is–we are nearing the peak interest rates in the economy. Let us understand this in a systematic way:
Peaking of interest rates
The Covid-19 pandemic changed the investment landscape a lot in a brief period of time. The Reserve Bank of India (RBI) cut the repo rate by 140 basis points between February and May 2020 to stimulate the economy. These cuts pulled down bond yields. Interest rates remained unattractive. Thereafter, supply side bottlenecks aggravated by geopolitical issues resulted in inflationary pressures across the globe. Central banks across the globe focused on reining-in inflation. Inflation shot higher than the upward acceptable limit of 6%. To deal with this, the RBI increased repo rate by 250 basis points over a period of time.
Repo rate, which touched 4% in April 2020, rose significantly by 250 basis points to 6.50%. However, now, things are changing slowly. In recent weeks, inflation has come down in most parts of the world. There is an expectation of an economic slowdown as well. The Indian economy may not go through a recessionary phase like its developed market counterparts. But it may see some slowdown in some segments of the economy.
Generally speaking, the central bank’s monetary policy has twin objectives—to target inflation as well as stimulate economic growth. Central banks generally walk a tightrope as they have to maintain balance. Lowering interest rates may lead to higher growth and higher inflation. And increasing interest rates may lead to lower inflation and lower economic growth. In this context, to ensure growth, the RBI may not increase interest rates for some time. Most market experts point out that we are nearing a rate hike cycle. Though the RBI has not officially changed its stance to neutral from ‘withdrawing of accommodation’, bond yields in the secondary market indicate that we are nearing the peak interest rates in the economy.
Staying flat
Now, let us understand the other side of the story. There may be a few investors who may be worried about interim volatility. A pertinent question which may be weighing on their minds may be: What if interest rates go up further? And this is a valid concern. It is important to understand that no one can spot a peak of bond yields. It is possible only in hindsight. There is a possibility of a rate hike in the next monetary policy. A sudden spike in inflation such as the one reported for January 2023 may rattle bond markets. In tandem, yields too may move up across maturities. But the broad trend indicates that we are nearing the peak.
The RBI may keep the repo rate unchanged for longer than expected. There may be bouts of volatility. Smart investors should capitalize on such volatile phases and spikes in yields by investing in well-managed portfolios. Such a staggered approach works in favour of investors as it will help them average out their yield on the portfolio. Each time yield spikes, there will be some mark-to-market losses on a fixed income’s portfolio. But they are worth taking. Investors staying out of the market hoping for volatility to go down are exposed to the risk of investing too late. Such investors may walk in only after yields go down considerably, which may not be remunerative at all.
What you can do?
In the context of these facts, fixed income investors will have to analyse current bond yields. Current yields are attractive and as inflation is expected to come down, investors too should pocket positive real returns (nominal return minus inflation) on their bond investments.
Investors can consider locking in their money at this juncture. Current yields-to-maturities of bond fund portfolios indicate attractive accrual income for conservative investors. It makes sense to remain invested and stagger incremental investments in bond funds to pocket accrual income and further benefit from any downward movement in bond yields. Importantly, investors should ideally select schemes with duration that matches their holding period.
Parijat Agrawal is head - fixed income, Union Mutual Fund
