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Debt Monthly Observer for July 2022 By Pankaj Pathak, Fund Manager- Fixed Income, Quantum Mutual Fund.

Outlook

Markets tend to pre-empt policy moves. Yields on medium to long term bonds had moved up over the last 12 months to price for the rising inflationary risks and potential rate hikes by the RBI.

At current valuations, much of the potential rate hikes are already priced in the medium to long duration bonds. Thus, the bond market may not be too sensitive to RBI’s rate hikes going forward.

As the RBI delivers on the expected rate hikes, short-term interest rates – yield short-term treasury bills etc. should move higher proportionately. However, long term bond yields may remain in a tight range or move up only marginally.

We found a similar trend in past. In all the previous rate hiking cycles, maximum jump in yields had happened up until the first-rate hike. Thereafter, yields moved up only marginally or got stuck in a narrow range.

Chart – VI: Bond Market has run ahead of the Policy rates; Much of the potential Rate Hikes are already Priced

There is still a risk of yields moving up due to an unfavorable demand-supply balance. Long-term bonds (above 5 years maturity) are more exposed to this risk as their prices are more sensitive to interest rate changes. When market interest rates rise, long term bond prices fall more compared to prices of shorter maturity bonds.

Since we are in a rising interest rate environment, at this stage our goal should be to have higher accrual with a lower maturity/duration. In our opinion 2-5 year maturity bonds offer this critical balance between accrual (interest income) and duration (price changes).

Portfolio Positioning

In the Quantum Dynamic Bond Fund (QDBF), we have been avoiding long-term bonds for some time due to our cautious stance on the markets. The defensive positioning helped the portfolio ride through the market sell-off over the last 6 months.

The bulk of the QDBF portfolio is currently positioned in the 1-3 years maturity bonds. We continue to like the 2-5 year segment of the bond market and maintain our cautious stance on the above 5-year maturity bonds.

However, we would remain open and nimble to exploit any market mispricing by making a measured tactical allocation to any part of the bond yield curve as and when the opportunity arises.

We stand vigilant to react and change the portfolio positioning in case our view on the market changes.

What should Investors do?

The interest rate on short-term treasury bills has jumped about 160 basis points (1.6%) in the last 6 months. With more rate hikes coming, short-term treasury bill rates are expected to move higher in the coming months. This suggests higher potential returns from investments in liquid and debt funds going forward.

Since the interest rate on bank saving accounts are not likely to increase quickly while the returns from liquid funds are already seeing an increase, investing in liquid funds looks more attractive for your surplus funds. Investors with a short-term investment horizon and with little desire to take risks should invest in liquid funds which own government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default.

Investors with more than 2-3 years holding period can consider dynamic bond funds which have the flexibility to change the portfolio positioning as per the evolving market conditions.

Medium to Long term interest rates in the bond markets are already at long-term averages as compared to fixed deposits which remain low. With higher accrual yield (interest income) and relatively lower price risk (compared to the last two years), dynamic bond funds are appropriately positioned to gain.

However, investors in debt fund dynamic bond funds or any other medium to long-term debt funds should be ready to tolerate some intermittent volatility associated with the movement in the market interest rates.

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