How Fixed-Income Investors Can Gain From Rising Rates
While higher interest rates have raised borrowing costs, they also offer opportunities for better fixed-income yields.
A major trend in global financial markets this year has been the battle of central banks against rampaging inflation. Most major central banks have hiked policy interest rates aggressively to tame decades-high inflation. Key among them, the U.S. Federal Reserve has raised its federal funds rate by 300 basis points over the past seven months.
In India too, the Monetary Policy Committee of the Reserve Bank of India has raised the policy repo rate by 140 basis points so far and is widely expected to hike it further at the end of the week.
While the increase in interest rates has resulted in higher borrowing costs for individuals, it has also presented opportunities for better yields on fixed income investments.
With this in mind, it is important for investors to adjust their strategy to make the most of higher yields.
Bond Yields May Be Close To Their Peak
Bond yields often run ahead of changes in policy interest rates. From its low point of below 6% in 2020, the yield on the 10-year benchmark government bond moved higher to around 7.6% this year. Earlier this week, the yield was hovering close to 7.4%. Long-term yields in India are unlikely to rise in proportion with the policy repo rate, with the bond market having already factored in a rate hike by the central bank. So, investors should contemplate starting to lock in higher yields in long-term fixed income options.
Take A Staggered Approach
It is hard to predict the course of global geopolitics. A prolonged war in Europe and an economic slowdown in major economies could continue to disrupt global trade. In India too, it is difficult to pinpoint when inflation will peak or how high bond yields can climb. So, long-term allocation in an individual’s debt portfolio should be done in a staggered manner over the next several months.
This will ensure that a part of the amount can be locked in, while retaining the opportunity to earn higher returns yields rise further.
Which Fixed Income Instruments To Consider?
One of the best options available to lock in higher rates for the long term is target maturity funds. These are open-ended funds that have a fixed maturity date. The bonds that the fund buys all have the same maturity and are held till that date.
The Bharat Bond ETF is an example of this kind of fund where there are maturity options for 2023, 2025, 2030, 2031 and 2032. Similarly there are target maturity funds for State Developments Loans (SDL), PSU Bonds, and AAA bonds of various maturities. The investor can choose the option that matches their specific time horizon as well as the kind of investment exposure they want.
Dynamic bond funds are also a good option to tackle the current uncertainty, while also retaining the ability to capitalise on future developments in the debt market. In these funds fund managers shift investments between longer and shorter duration instruments based on their assessment of the trends in the debt market. These help investors gain from the emerging situation without having to move their investment around on their own.
What To Watch For
If the investor adopts a strategy of building their long-term debt portfolio in parts, they would need some variety in their choices. They would also need to keep some areas under watch as these might present opportunities going forward.
Banking and PSU debt funds are another category of funds that many investors can consider for the longer term. These funds will see a negative impact if rates keep rising but they are candidates that can be added to the portfolio once there is stability on the inflation front. The credit risk factor is mitigated in these funds and higher yields over the longer term can benefit investors.
Among traditional investment options, bonds and debentures from highly rated infrastructure and financial companies can also be a good addition to the portfolio.
(Arnav Pandya is founder of Moneyeduschool.)