The year 2022 has seen unprecedented events. As the world emerged from the disruption caused by Covid-19, the onset of the Russian-Ukrainian conflict, coupled with other economic headwinds, led to a spike in commodity prices, causing even more volatility in financial markets. of the whole world. Many developed countries have been hitting high inflation rates for several decades, forcing their central banks to opt for inflation-targeting monetary policy, which has led to an aggressive rate hike cycle. As a result, interest rates have skyrocketed globally and most currencies have become even more volatile.
With us, the situation is not very different. The Reserve Bank of India (RBI) has also hiked the repo rate – the rate at which banks borrow from the central bank – four times since May 2022, and it is expected to raise policy rates further before pausing. Against this backdrop, fixed deposit (FD) rates rose slightly. In such a scenario, the question arises: should we invest in FDs to take advantage of rising rates? Or are debt funds a better option when many believe interest rates are approaching their peak? Or is it better to invest in corporate bonds?
Let’s take a look at the state of the different segments of fixed income securities and the strategy to follow to get the maximum benefit from them.
Let’s start with debt funds. The RBI has raised rates and reduced liquidity in the system over the past year, leading to higher yields across all maturities. Example: Over the past five months, the repo rate has been raised by 190 basis points (bps) to 5.9%, while the benchmark 10-year G-sec yield has risen by 160 bps to 7, 4%. Thus, over the past year, debt funds have not performed well, as they have seen the prices of their holdings fall; because when interest rates go up, bond prices go down and debt mutual funds (MFs) have to mark their net asset values (NAVs) to market daily, as bond prices go down , NIVs also suffer. “Loan funds have seen investors withdraw almost Rs 2,000,000 this calendar year and returns have been mostly positive at 3-4% annualized,” says Sandeep Bagla, CEO of TRUST Mutual Fund.
So is now the right time to invest in debt funds? “We recommend investments in funds with a portfolio or portfolio maturity of two years or less. It is entirely possible that inflation will remain stubborn and that yields will remain high for a long time. At this stage, we would only advise 5-10% for longer-term funds, around 25% for liquid/money market funds and around 65% for short-term funds or BPSU (bank and PSU) debt funds. with a roll-down maturity of less than two years,” explains Bagla.
Similarly, if you have a medium-term horizon (four to six years), don’t mind short-term swings in returns, and are looking at after-tax returns, then a class of debt fund, called Target Maturity Funds, scores higher than FD. “Target maturity funds offer returns (net YTM) of around 7 to 7.25% over a period of four to six years. They invest primarily in government securities, PSU bonds and government development loans (SDLs), and the instruments are held to program maturity. They are a good investment option if treated as open fixed maturity plans (FMPs),” says Alok Agarwala, Research Director, Bajaj Capital Ltd.
Since there are 16 Sebi-defined categories in debt funds, the easiest way is to match your investment horizon to the plan’s average maturity.
“Both debt funds and trust funds have advantages and disadvantages relative to each other. Debt funds carry interest rate risk which makes them unattractive when interest rates rise. But they also have a lower risk of default because they have a highly diversified portfolio. Also, the income tax on earnings from debt MFs is significantly lower than that of FDs,” says Agarwala.
The tax advantage also makes debt funds attractive. “When bond rates are rising faster than FD bank rates, investing in bond funds should provide a higher portfolio return than FDs. If an investor holds an investment in money market funds for more than three years, the investor will have to pay Long Term Capital Gains Tax (LTCG) with indexation benefit. Therefore, the after-tax returns of debt funds could be much higher than those of bank debt funds, as there is no tax benefit to holding deposits for three years,” Bagla explains.
Currently, it is advisable to lock your funds only in short-maturity patterns, as inflation may remain high for a long time. However, always invest according to the risk profile. For a complete risk-free investment, FDs are definitely better. “For example, in FDs, while bank deposits carry a low interest rate of 5.45-6.10%, some AAA-rated corporate deposits carry a coupon of around 7% or slightly higher, which which, coupled with a lack of interest rate risk, makes it an attractive proposition,” says Agarwala. But, if one wants to take advantage of changing interest rates, debt funds could be the choice.
Now let’s move on to corporate bonds. While investing directly in bonds, consideration should be given to the interest rate cycle and the maturity of the securities, as interest rates and bond prices are inversely correlated. For example, if you hold a long-term bond with an interest rate of 10% and the rate rises to 12%, the value of your bond will decrease. The change in the price of the bond is based on the movement of interest rates. The longer the duration of the bond, the greater the impact on the price of the bond. But, if you stay invested, at the end of the term, you will get the coupon rate that was locked in when you bought the bonds.
Currently, with rising interest rates, corporate bonds offer a much higher yield (up to 13%) than FDs (5-6% for a one- to three-year term). “Corporate bonds in the fixed income category are one of the best options to invest in. Currently… the best performing corporate bonds [are]… Muthoot Fincorp (subordinated debt) with a yield of 10.50%; Indiabulls Housing Finance Limited (unsecured) yielding 14.25%; and Piramal Capital & Housing Finance Limited (secured) with a yield of 11.4%,” says Ankit Gupta, founder of BondsIndia.com.
Not only corporate bonds, but also government bonds are doing well. “On a 10-year paper, government bonds offer a yield of around 7-8%, which is pretty decent compared to G-secs,” adds Gupta.
Although it is easy to be swayed by high interest rates, note that this instrument carries a high credit risk. Therefore, while investing in FDs and corporate bonds, one should check the credit quality of the issuer and also diversify the investments evenly across at least four to five issuers. “Never invest all your money in bonds or FDs of a single issuer or companies in a single sector. Given the current macroeconomic environment, invest only in bonds or FDs with the highest ratings, even if it means sacrificing some yields,” says Agarwala.
Then there are other secured options available such as RBI Floating Rate Savings Bonds where the yield does not vary with the movement of interest rates; they are issued by the Indian government. Here, investors can purchase the 2022 Floating Rate Savings Bonds with an interest rate of 7.15%, which is 35 basis points higher than the rate offered on the National Savings Certificate, and there is no there is no upper limit to investment. But, there is a lock-up period of seven years and the interest rate is announced in advance every quarter for these bonds.
For senior citizens, there are more options such as the Senior Citizens Savings Scheme (SCSS) offering 7.6% and Pradhan Mantri Vaya Vandana Yojana (PMVVY), a pension scheme. The PMVVY pays a pension at the insured rate of 7.4 per cent. The plan is for a fixed term of 10 years. One can invest up to Rs 15 lakh in the policy for a monthly pension of Rs 9,250.
Repo rates have risen significantly since hitting the bottom (4%) in April 2020. By carefully diversifying your fixed income portfolio, you can earn higher returns. But always remember that with higher returns come higher risks.