Floating rate funds and TMFs are good choices


What a VUCA world (volatility, uncertainty, complexity and ambiguity) we live in! Gold is sizzling, equities are sometimes raining and fixed income is losing momentum. The war has caused oil to boil, leaving investors’ wallets to do a lot more work.

Bond yields around the world have trended north in recent months, especially with the relentless rise in inflation in the United States. US inflation is now at 8.5%, while the yield on 10-year US government securities (g-sec) is below 3%. That is a negative real rate of more than 5.5%! We saw the US Fed raise rates for the first time in more than three years to combat the worst US inflation since the 1970s. As recently as December last year, markets were discounting three rate hikes in the current year 2022.

Now we are looking at 7-8 rate hikes for this year. Recession talk has gained momentum in the US, which is also reflected in the forward yield curve. Worldwide, the excesses that have been pumped into the system as steroids are pumped out – an attempt to return to the pre-pandemic era.

In India too, the Reserve Bank of India (RBI) finally bit the bullet towards a change in policy direction by being “less dovish” even though it kept the policy repo rate unchanged with a unanimous vote. The central bank has dealt with this by introducing a new tool – the Standing Deposit Facility (SDF), currently set at 3.75% – as a way to manage liquidity more efficiently. Thus, we have seen a 40 basis point rise in overnight rates.

Inflation in India continued to rise. The CPI for March 2022 came out at 6.95%. The RBI has raised the CPI forecast from 4.5% to 5.7% for FY2023. Further, the growth outlook has been lowered from 7.80% to 7.20% for FY2023. 2023.

This unambiguously expresses RBI’s preference to rank inflation over growth in its list of priorities. This is also consistent with the narrative of global central banks. The policy has clearly shifted gears from a dovish attitude to a more hawkish focus and nuance. The accommodative stance is now set to be withdrawn to ensure inflation remains within target.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 for all investors given the likely upward trajectory of interest rates. We have long argued that fixed income investors need to focus more on potential carryover capital gains this year. This view is becoming more entrenched as markets began pricing in rate hikes long before the actual event.

The current OIS (overnight index swap) curve indicates that the repo rate, which is 4%, will need to be increased by 150 basis points over the next 12 months – a very extreme reaction to RBI policy. It is equally important to note that the first half of FY23 will see 60% of the total government borrowing program. How the RBI (in the role of an Indian government investment banker) navigates this mammoth borrowing program would be a key determinant of the direction of bond yields going forward.

Therefore, investors are better off with strategies such as floating rate funds, target maturity funds and/or dynamic bond funds. These categories could act as potential shock absorbers and try to reduce the impact of volatility on the portfolio. For example, floating rate securities have periodic coupon rate resets. This helps in a rising rate scenario, as the coupon fixing tends to be higher, improving the overall return of the portfolio.

Similarly, target date maturity funds are open-ended in nature and investors have the flexibility to choose their preferred maturity date. This also helps to mitigate interest rate risk to a large extent, as the underlying securities are close to the target maturity date. The underlying credit risk is also known because the index components are made available before the launch of the fund.

Aggressive bonds tend to swing durations based on the interest rate outlook. This category can be a little volatile in the short term due to yield movements. However, it is a good category to have in your portfolio with an investment horizon of 3 years. The proportion of the quantity of each category to own is also a function of the time horizon and the appetite for risk that one has. Laddering investments is also a good strategy to try to reduce interest rate volatility.

Finally, it’s about making disciplined investment decisions and, more importantly, sticking to your asset allocation during times of market turmoil.

Lakshmi Iyer, CIO (debt) and chief product officer, Kotak Mahindra AMC.

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