Eighteen months ago, it would have been difficult to imagine that there would be a time when debt investors in India would be spoilt for choice. But the sharp rise in market interest rates in India in the past year or so, has led to this happy situation. Between December 2020 and now, yields on a range of debt instruments – treasury bills and g-secs, commercial paper and corporate bonds, State Development Loans – have climbed 150-200 basis points.
The table above shows just how steeply yields have climbed in the last year and a half. But now that rates are on a rising trajectory, it is tempting to give in to a little bit of greed! Today, we find many investors and advisors hesitating to lock into current rates in the hope that they can earn even higher returns from their debt investments in future.
Waiting for the perfect time – the very top of the rate cycle - to emerge, can lead to missed opportunities which you may regret later.
But given the difficulty of catching the top of a rate cycle (which is as tough as catching a bear market bottom in stocks), investors should not give in to this temptation. We think this is a good time for Indian bond investors to freeze on their debt strategy by locking into the good long-term rates. Waiting for the perfect time – the very top of the rate cycle - to emerge, can lead to missed opportunities which you may regret later.
PrimeInvestor was among early researchers to warn investors of the coming rise in interest rates through our debt outlook in January 2021and again in our debt outlook September 2021. We wrote about both inflation and rate risks. Having warned our subscribers quite early of the possibility of rising rates, and asked you to add short duration and floating rate instruments, we think the time is now right to lock into longer duration as well.
We see three factors that could lead to market interest rates pausing now, after their steep climb.
Pause ahead
#1 Global commodity cool-off
One of the key factors that have propelled interest rates higher for the last six months is the narrative about persisting inflation and supply shortages across commodities, even as demand normalised post-Covid. The Russia-Ukraine conflict coming out of the blue took the entire range of commodities from crude oil and natural gas, to cooking oils and wheat to new highs in March/April this year.
But with supply chains adjusting to Russia-Ukraine disruptions and demand moderating, prices of most commodities have since cooled off significantly from their super-heated levels of March/April. The declines have been substantial, of the order of 20%-50%. Analysts in the meantime have quietly buried their forecasts about the next commodity ‘super-cycle’ and are now speculating about how long this correction may last. Though energy prices remain elevated due to short supplies, the cool off in food and feed prices is likely to show up in the inflation numbers in the coming months. This has raised hopes that inflation numbers across the world, even if they don’t collapse in a hurry, may flatten out in the coming months. The recent spike in the US Dollar Index past 108 levels is also negative for commodities, as importing nations will find it costlier to import and may cut back on their demand.
#2 Concerted cool-off
#3 Recession fears
For commodity prices to remain elevated, the global economy has to remain buoyant, industries operate at high capacity and the capex cycle shows signs of a revival. But with global central banks withdrawing liquidity at a brisk pace and incomes hit by Covid and inflation and fears of recent rate hikes hurting consumers, global growth forecasts are now being lowered sharply. US forecasters are now beginning to actively predict a technical recession (two quarters of shrinking GDP) if not a structural one. China, one of the largest global buyers of commodities, has already been slowing sharply thanks to problems of its own making. This has led global agencies like the IMF to sharply lower their growth forecasts for 2023.
Global growth in 2023 being expected at only half the levels of Covid hit 2021, doesn’t augur well for a continuation of a rising rate cycle. For one, dwindling global growth is bound to hit demand for commodities, holding back a spiral in inflation. Two, central banks too are likely to be wary of taking the unpopular step of going on raising rates when borrowers and the economy are in poor shape. This may lead to a pause in the global rate hiking cycle sometime later this year.
#4 RBI’s balancing act
In India too, after falling behind the inflation curve and hiking the repo rate sharply in the last two policy reviews, RBI seems to be preparing the ground for a pause in rates later this year. For one, India is unlikely to be immune to the global slowdown with RBI revising its growth forecasts for India down to 7.2% for FY23 from 7.8% earlier. This will force RBI to strive for a better balance between inflation control and growth stimulus in its upcoming policies. Two, RBI usually takes the view that rate hikes or cuts take 2 to 3 quarters to trickle down to the markets, in which case it may like to wait and gauge if its hike of 90 basis points in the repo rate in the last six months has managed to kill inflation. The RBI governor has hinted at this in a very recent interview. This comment saw market g-sec yields cool a bit from recent highs.
All this leads us to believe that market yields may not spike up much more from current levels at this stage in the rate cycle. We think that a yield of about 7.4-7.5% on the 10 year g-sec, 7.3% on the 5 year g-sec and about 6% on 1 year T-bills represent attractive rates for investors to freeze on their debt strategies.
Bond investors also need to keep in mind that even if the MPC remains hawkish and decides to hike the repo rate by another 25-50 basis points in the next policy to make sure that inflation is quelled, market interest rates may not rise by the same magnitude. Bond markets like stock markets, always discount events before they unfold. Short-term interest rates in the market have run up over 200 basis points from their lows, while the repo rate has risen only 90 basis points.
All this leads us to believe that market yields may not spike up much more from current levels at this stage in the rate cycle. We think that a yield of about 7.4-7.5% on the 10 year g-sec, 7.3% on the 5 year g-sec and about 6% on 1 year T-bills represent attractive rates for investors to freeze on their debt strategies. Though there could be an upside of 25-30 basis points left, waiting indefinitely to catch rates at their absolute top can backfire in the form of missed opportunities to make the most of the attractive rates prevailing now. Yes, corporate bond spreads and deposit rates from leading banks have been slow to move with the spike in g-sec yields and have some catching up to do.
Your debt strategy
Taking the view that we may have hit an intermediate high in market interest rates, especially in g-secs, here’s how investors can approach their debt investments now. It is best to formulate your debt strategy based on the time horizon for which you are seeking to invest and the number of years you have before you need your principal back.
#1 Very short-term investment
While market yields on g-secs have run up rapidly, the interest rates on post office schemes have stayed put with the government reluctant to revise rates upwards. Similarly, systemically important banks such as SBI, ICICI Bank, HDFC Bank and other PSU banks have been very slow to react to the changing market dynamics.
We therefore think that the best parking ground for your short term need (less than a year) today lies in treasury bills (91, 182 or 364 days) or in deposits with better quality small finance banks or NBFCs that are willing to offer competitive rates to depositors. To invest in treasury bills, you need an account with the RBI Retail Direct platform. During Covid and just after it, we were worried about private banks and retail NBFCs running into troubles from Covid related retail lending and RBI’s moratorium. But numbers show that leading private banks, SFBs and high quality NBFCs have weathered this period extremely well and are now sitting on a combination of low NPAs, high capital cushions and strong liquidity, which makes their deposits a safe proposition. This has prompted us to leave out systemically important banks and introduce good quality SFBs and NBFCs into our Prime Deposit recommendations and you can pick parking grounds for your emergency money from here.
#2 Upto 3-year investment
With short term rates in the market rising quite fast, two options fit the bill for debt investments that you’d like to hold for 3 years or less. In these your options are:
- Pick NBFC deposits that we’ve recommended for 24-36 month tenures
- Or from our Prime Funds in the short-term debt category.
Investors often make the mistake of comparing the two, to conclude that deposits are the better bet. After all the FDs sport returns of 6.5-7% against trailing returns of 3-4% on short term debt funds. But this is an apples to oranges comparison because the deposit returns you’re looking at are future returns while the returns on short term debt funds are backward looking. As market interest rates rise, you can expect debt fund returns to float up sharply. The current portfolio YTMs (yield to maturities) of the short term funds in our recommended list are in the 6.7-7.2% range. Given their direct expense ratios of 0.20-0.30%, net returns in the next year or so can be expected in the 6.2-7% range, quite comparable to the FDs. The post-tax also works favourably in mutual funds, if your holding is for 3 years. For income/cash flow: If you are a Growth subscriber you can also keep a watch for our ‘high risk private bond’ recommendations too to locate high yield opportunities if you prefer some cash flow/interest pay out.
#3 4 to 7-year investment
With yields on AAA rated companies not offering enough of a risk premium over g-secs, we see two pockets of opportunity for debt investors with a holding period of 4-10 years in mind. One, they can invest in target maturity passive debt funds that invest in gilts or SDLs (State Development Loans) which offer very good risk-reward currently. We have already listed four such passive funds in this earlier article. The yields on these funds remain at very attractive levels for investment.
Do note though, that you should buy the passive MFs only if you plan to hold on to them until their target maturity date. If market interest rates rise further in the next few months, your near term returns from such funds can be low or even negative. However, given that these funds receive regular interest payouts from the bonds they own, the returns by way of income tends to make up for the short-term NAV losses from falling bond prices. Plus, the bonds will be redeemed at face value when the fund matures. Please note that if you already hold corporate bond funds from Prime Funds, you don’t need to replace them with these.
For regular income: If you seek regular income and not growth and don’t like interim NAV volatility, then participating in primary auctions of 5 year g-secs and SDLs which offer attractive yields of 7-7.5% offers a good bet too.
#4 Long-term investment
If you have been looking for good debt options for goals that are 7 plus years away or are a long way away like retirement, then this is a good time to lock into attractive rates via 10-year constant maturity gilt funds. These funds tend to own only sovereign instruments with the average maturity approximating 10 years and thus mimic the performance of the 10 year gilt in the market. This appears to be a good time to enter such funds, because the downside to bond prices from here appears limited and the fund will get to earn interest at 7.4-7.5% yield for the long term from current levels. Just like the passive funds mentioned above, these funds may deliver low or even negative returns in the short run if rates rise further. But in the long run, the high interest rates and the normalisation of the rate cycle will smooth out your returns to deliver good compounding. Check Prime Funds to choose our recommendation in constant maturity.
If you need income: If you seek regular income for the long term, and don’t like market-based volatility in your debt returns, then buying into 10 year g-sec auctions with a 10-15% allocation to SDLs from the leading States such as TN, Maharashtra, Karnataka etc would be a good proposition.
37 thoughts on “Prime Strategy: Time to lock into high yields and how”
Dear Aarti, Congratulations for a very nice article
This pertains to 4 yr + horizon investment in target maturity funds as mentioned in article.Since these are new products kindly clarify
If YTM of a 5 yr target maturity fund at launch one year ago, was 6.15% and expense ratio .15% ie net yield of 6% is it safe to assume that at maturity NAV would be Rs 13(0.6*5=3) despite NAV fluctuations till maturity.
If the current ytm of such fund is 7.2% and NAV Rs 10.40 one will still get Rs 13 at maturity, which is lesser return than indicated YTM of 7.2%.Have I understood correctly or am I missing something?
What relationship between YTM and final returns should one take in target maturity funds?
Most target maturity funds invest in diverse SDL. Some states are not in good financial health
What about safety of SDL?If a state defaults,then does RBI have the power to cut the state’s grant and not allow SDLs to default ?
Hello Sir, As with all open ended funds one cannot make a full assumption. it is indicative and can change based on inflows and outflows. For SDLs – thre is a sovereign guarantee indirectly since RBI cannot allow them to default. thanks, Vidya
Your understanding is correct that the final maturity amount you expected at the beginning should remain unchanged, in a target maturity fund. The YTM rises only because prices are lower due to higher rates. You are perhaps not factoring in the impact of expense ratios in reducing the final returns. Yes while some States are not in great financial health,the target maturity funds mentioned here invest in SDLs from the bigger States which are quite unlikely to default. There has been no case so far of a State defaulting on an SFL though there have ben defaults on State backed bonds like Amaravati Bonds. RBI manages repayments on SDLs via an escrow account.
Thanks for the info. For long term debt investment 7+ there is only one constant maturity gilt fund in Recommendations “SBI Magnum Constant Maturity Fund”.
Is this the only one recommended?
Thanks,
Just replied through ticket. Thanks, Vidya
We choose funds based on track record and this is the only 10 year constant maturity fund with a long enough track record.
Arati, thanks for the article. A quick question:
Why is there such a high return differential between the sbi 10 year constant maturity and the nifty 10 year gsec index? An investment in Apr-2006 in the sbi 10 year constant maturity nets you a cagr of ~8%, while the nifty 10 year gsec index you’d get about 6.05%. (Not just point 2 point, but it has outperformed throughout).
More perplexing is that the nifty 10 year gsec index also trail the nifty 5 year gsec index. The 5 year would have a cagr of 7.8%. The 10 year seems to be left lagging way behind.
Constant maturity will make some capital appreciation gain by selling and buying (it is required to maintain only an average of 10 years and not every bond needs to be 10 years). On the 5 and 10 year – yes, the yield spread between 5 and 10 year is never too high in the Indian context and 5 year is less volatile than a longer dated paper. So unless one holds the 10 year to maturity, lower losses (in rising rate scenario) ensure 5 year beats the 10 year. the reverse would if we are at the peak of a price rally (rate fall). thanks, Vidya
SBI resorts to some degree of active mgmt by owning 8 and 13 yr gilts averaging out to a 10 year average maturity. This could explain better returns though it comes with higher active risks. The differential between 5 year and 10 year gilt is not wide because in India term premiums (diff in yields) between 5 and 10 years are typically not very significant. As the 5 year reacts less to a rise in rates than the 10 years, the investor overall gets the benefit of high yield with lower volatility with the 5 year.
Bala/Aarati,
Thanks for the reply.
But this sort of muddles the waters. If we are saying that the spreads between the 5 years and 10 years has historically been slim in India, which has allowed the 5 year to be the safer bet (lower losses) and thereby also delivering higher returns… the obvious question is why recommend the 10 year?
Is this essentially a call by primeinvestor that the spreads will likely widen in favor of the 10 year (despite this not being the case in history?) or is it a call on the specific fund: the SBI 10year has great active management thus far, hence a bet on it?
Please note, the outperformance of the nifty 5 year index over the 10 year is very significant. Its huge. Infact, its only a slight bit lesser than the SBI 10 year (8% vs 7.8%).
I wonder if we are overlooking something (more specifically: something different about the 10 year index that we are missing?). The reason I ask, is its not just the 5 year that outperforms it. Shorter durations also seem to outperform. I don’t have an index to compare against, but you could take some thing like HDFC money market… 7.3% vs nifty 10 years’ 6.04.
Sir, In terms of yield a 10-year yield has been and will be (normally) higher than 5 year and in India too, that has been the case, if you check 5 yr and 10 yr g sec historically. That primarily means yield to maturity. So no change there. The spread will decide which one earns better for les than . Over 5 years – a 10-year will naturally be more volatile than a 5 year and hence can lose more. This is why in our passive debt strategies we have mostly gone with 5 year https://www.primeinvestor.in/four-passive-debt-funds-to-invest-right-now/ And since constant maturity is not passive, I am not sure if this comparison with the 5-year index works. Besides, we give it for more than 5 year (like 7 year portfolios), if you check Prime Funds. Thanks, Vidya
Since there is not much difference in 5 yr Gsec yield and 10 yr Gsecs,and I beleive 10 yr constant maturity funds are more volatile than normal medium duration gilts ,could you please recommend a gilt fund for long duration for sip mode for 7 yrs + horizon for peoplle who may sacrifice .5% return for a lot less volatility,zero credit risk and if duration is managed actively would be a plus point
Kindly refer to primeinvestors fund recommendations.
Tax free bonds offering yield of 5.5 percent from secondary market can also be considered for ppl in 30 percent tax slab
Well explained. Thanks. Can you also share % of allocation for respective categories when building debt portfolio/strategy ? For moderate risk investor
Hello Sir, It is time frame based and hence giving a % allocation does not work. So the allocation should be based on your time frame. If you had a longer time frame, no harm adding 30-40% in short term. But if your time frame is short, then you cannot expose to longer duration. thanks, Vidya
We don’t like to give % allocations because this should be individual specific. Basically if are very conservative, you should go for a maximum allocation to central g-sec funds and must add allocations to SDLs if willing to trade off higher yields for slightly more risk.
Hi Aarati,
Thanks for the informative article. My question is regarding #4 Long term investment – do you see any benefit of locking in yields for a much longer duration in a pure GILT scheme like Nippon India Nivesh Lakshya if the funds are not required for more than 10 years? Or, is a 10-year GILT CMF the better option?
We feel the 10 year constant maturity reduces the risk of active management by the fund manager going wrong. Lower expense ratios also make the constant maturity fund more attractive.
In reply to Mani’s question, you have mentioned that SBI 10yCMF resorts to a degree of active management by buying papers of 8y and 13y duration (averaging it to 10y). Right now the bets are in the fund’s favour and the returns are higher than the 10y GSec returns but it can turn lower depending upon the fund manager’s call.
Would you still consider it to be a passively managed fund or the degree of risk is acceptable in the view of no other MF having a pure passive 10yCMF?
Constant maturity is not a passive fund. it is very much an active fund with a constant average maturity. Just that the constant maturity makes it less active compared with other debt funds. Otherwise there is definitely a good degree of active management necessary in such funds. Returns cannot be way away from 10-year G-Sec simply because they need to maintain the average maturity still. thanks, Vidya
the four target maturity passive funds recommended here have run up in the last one month.
Would it be prudent to make a lumpsum investment at this point of time? or should one spread investment over the next 3-4 months?
Yes a lumpsum would be better because you are trying to lock into an elevated level of yield, and it is difficult to catch the top.
Hi Aarati,
Thank you for this wonderful article. One question:
For the long term debt investments with no requirement of regular income, will it be a good strategy to invest in equal proportion in IDFC 2027 Gilt index fund, one of the 2027 SDL Index fund , one of the 2032 Gilt Index fund and in 2032 Bharat Bond ETF? Would appreciate your comments. Thanks.
Yes but the 5 year target maturity funds will mature in 2027 and you will need to reinvest that money at prevailing interest rates. Those rates may or may not match up to the current long term yield of 7.4%.
Hi Aarati … Very good take on debt fund scenario but the only X factor is future Fed rate hike in view of sticky & high US inflation. With spread between 10 yrs India gsec & 10 yrs US bond rates at levels way below historical average (spread may decrease due to July Fed rate hike) & the fact that Indian inflation is due to supply side constraints, India interest rate is beyond RBI control unless it is comfortable with outflow of USD.
My two cents: One should at the least wait out till July Fed outcome and RBI reaction to the same.
Educated insight from you on the matter will be appreciated.
Regards
Jatin
You are absolutely right that matters can get taken out of RBI’s hands. But the only thing that gives me hope is both RBI and govt are exploring a lot of non rate, non monetary measures to manage the Rupee such as the FPI relaxation in short term bonds, removal of rate ceiling on FCNR deposits etc. Slightly cooling crude will also give a respite on FPI pullouts. Rupee also seems to be doing not too badly against most currencies. I feel market rates will react ahead of RBI pause. Though yield may yet move to 7.6-7.7 etc that 20-30 bps upside may not make a big diff to long term returns, given that downside risk too exists.
Hi,
I have a question on the SDL
1. since the holdings of the MF seem to be in the higher interest rate, is it possible that the present NAV has already risen enough that the actual returns (if held till maturity) will be the same as the holdings they have , or is will it be lesser assuming that the NAV has already risen?
Thanks
Yes from here it would better to bet on returns coming from high current interest rates rather than any appreciation in NAV.
Thanks a lot for the reply Aarati, Just wanted to confirm one more understanding. Generally in order to calculate potential returns from Accurals, would it be fair to say, that the YTM during the day of buying the SDL Mutual fund would be the approximate returns.
Thanks
Just replying on her behalf. Roughly yes – less expense less any other fluctuation due to low turnover of any paper. thanks, Vidya
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