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How to maximise returns from debt portfolio

Debt funds need to be held for three years to qualify for long term capital gains tax at 20% with indexation benefit.Premium
Debt funds need to be held for three years to qualify for long term capital gains tax at 20% with indexation benefit.

  • Prior to the pandemic, holding a debt fund with underlying credit quality at AAA and three-year maturity would have sufficed to beat retail inflation, which typically averages at 6% per annum. However, with prevailing yields low, this strategy needs a complete overhaul

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In the current fixed income market, yields across the curve have bottomed out and the yield curve is extremely steep. Prevailing term yields for AAA PSU Bonds as on 4th Jan’22 as per Bloomberg are 4.66% for one year, 5.57% for three years, 6.16% for five years and 7.03% for ten years.

As rates rise going forward, the yield curve is expected to flatten, which means that the shorter end of the curve (1-3 year) is expected to rise faster than the longer tenures (10 year).

During the IL&FS crisis in November 2018, the yield curve was flat and yields were much higher. For instance, the one-year AAA yield & the 10-year AAA yield were both at 8.8%.

Prior to the pandemic, a simple strategy of holding a debt fund with underlying credit quality being AAA and three-year maturity would have sufficed to beat retail inflation, which typically averages at 6% per annum in India.

However, with prevailing yields being so low, this strategy needs a complete overhaul.

Short maturity funds are not sufficient to beat inflation, whereas having only long duration funds (10 year maturity) poses high interest rate sensitivity and is subject to high volatility.

A ‘Barbell’ fixed income investment strategy involves creating a portfolio with a combination of short term debt instruments and long term debt instruments to get an optimum mix of yield and duration (interest rate sensitivity).

In today’s context, we suggest creating a barbell portfolio where (i) 65-70% should be invested in AAA-oriented roll-down strategy funds with 3-5 year maturity where yields are in the range of 5.50-6.00% p.a., and (ii) the balance 30-35% can be invested in AAA-oriented roll-down strategy funds with 10 year maturity where yields are closer to 7% p.a.

This would effectively provide a portfolio where the weighted average maturity profile is around 5.5 years (i.e. duration of ~4 years), and importantly the yield could be slightly higher than 6% p.a.

At the same time, roll-down strategies would ensure that interest rate sensitivity or portfolio duration keeps reducing with every passing year.

Passive roll-down debt funds, e.g. Bharat Bond funds, PSU Bond plus SDL funds, are best suited to construct such barbell portfolio strategy as their portfolios consist only of AAA-rated instruments and State Development Loans (SDL), the latter being at par with G-secs when it comes to sovereign credit.

Note that this strategy is suggested for those investors with minimum three-year investment horizon. Debt funds need to be held for three years to qualify for long term capital gains tax at 20% with indexation benefit.

(Nitin Shanbhag is head of investment products at Motilal Oswal Wealth.)

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