By- Amit Vyas, Head- Products & Research – Wealth, Equirus

Fixed Income asset class is an integral part of strategic asset allocation for any long-term investor. Fixed-income securities reduce the overall risk in an investment portfolio and protect against volatility or wild fluctuations in the market.  In general terms, fixed income investing can potentially provide investors with benefits such as assets with a focus on capital preservation, income generation and diversification from
stock market risks.

Whilst fixed income is a deserving asset class and has merits, investors should be aware with the associated risks to fixed income investing. There are broadly four types of risks when it comes to fixed income investing.

First, Interest rate risk – When interest rate rises, bond prices fall.

Second, Inflation risk – If the rate of inflation outpaces this fixed amount of income, the investor loses purchasing power.

Third, Credit risk – Also known as business risk or financial risk, is the possibility that an issuer could default on its debt obligation.

And last but not the least, Liquidity risk – Liquidity risk is the chance that an investor might want to sell a fixed income asset, but they’re unable to find a buyer.

If you are closely tracking the fixed income asset class, there is no denying the fact that fixed income portfolio has been a wash out in the past 3 years. For a period of 1-2 years, FDs scored marginally over the liquid and ultra-short duration funds. Having said that, the only comfort investor may draw is, that the post-tax returns over a 3- year period for short /medium duration funds such as corporate bond funds have
delivered better than FDs.

The primary reason behind this is that for a little over 2 years between May 2020 and April 2022, the RBI kept rates unchanged. Rate moves are necessary for fixed income strategies to work.

The fall in interest rates benefits fixed income strategies / bonds as the bond prices are inversely corelated to yields. So, when interest rate falls, bond prices go up. This is how the investors make capital gains in fixed income securities. One needs to understand the fact that just like any other asset class interest rates also go through cycles. But in a flat to low rates scenario, you neither have higher yields to lock into, nor is there a price rally to gain from capital appreciation. Therefore, the last 2-3 years were not that good for fixed income funds.

But the good news is that the sharp rate hikes since April 2022 and a spike in yields in the bond markets have led to yield to maturity (YTM) of funds/bonds moving up sharply. Interest rates across the world markets have inched up on the back of hawkish monetary policies by central bankers to control spiralling inflation. We have seen multiple rate hikes in the past 3-6 months across major economies. India 10 Year G-Sec which was 5.9 on 31 st Dec 2020 is now trading 7.20-30 and abouts.10 Year G-Sec is a benchmark for the other fixed income securities like bank cd, corporate bonds, SDLs, commercial paper etc. The yields have gone up by 150-250 basis points across the various debt instruments.

How should an investor create a fixed income portfolio? Let’s try and answer these questions!

It is best to formulate your fixed income 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.

The investment time horizon should ideally match with the average maturity of the fixed income strategy. The broader idea is to avoid the trap of predicting interest rate cycle. Interest rate rallies can be as quicker or longer and the timing, magnitude and pace of these rallies cannot be ascertained.

One should also avoid taking aggressive credit risk. High yield credit can give an investor 1% -3% P.A more but can be extremely volatile when the credit environment is not conducive.

With the above framework, let’s look at the options for different time horizons and how an investor can rebalance portfolio with the present rate situation.

1. Very short-term Investments –

Liquid & Money Market mutual funds are best suited for all your short-term investments. Treasury bills (91,182 or 364 days), deposits with better quality small finance banks or NBFCs can also be an alternate to park very short-term funds. One needs to open an account with the RBI Retail Direct platform to invest in treasury bills.

Investors should look to diversify the investments across the products and issuers and avoid issuer specific risk.

2. Up to 3-year investments –

We have already seen the short-term rates going up in the markets. This makes the short-term mutual funds an attractive option along with NBFC deposits with 24–36-month tenure (Stick to AAA/AA rated only). Investors should not compare the two as the NBFC deposit rates are looking at future returns and short-term MF returns are backward looking. The current portfolio YTMs (yield to maturities) of short-term funds are in the range of 6.65% to 7.25% range. The post-tax returns work favourably in mutual funds, if the funds are not redeemed before 3 years from the date of purchase. One can have a combination of short term, Banking & PSU & Corporate bond funds in this space.

3. Four-to-Seven-year investments –

Target maturity passive debt funds that invest in gilts or SDLs (State Development Loans) offer very good risk-reward currently. The yields on these funds are at very attractive levels for investment. It’s important that you buy these passive MFs only if you plan to run down the maturity and hold on the funds until the target maturity date. These funds in the short term can show low to negative returns if the interest rates rise. But these funds get regular cash flows from the securities they are invested in and that compensates for the negative return over a period. These funds should be invested with hold till maturity view. 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 Investments –

10-year constant maturity gilt funds offer attractive yields and one can stagger the investment in this category over a 3-to-6-month period. This category funds invest in 10-year g-sec and carry an average maturity of 10 years. These funds are the best options for financial goals like retirement that are 7 plus years away. These funds invest only in sovereign instruments and mirror the performance of 10-year g-sec. It’s very difficult to time these funds and being long duration funds, these funds may give negative returns in the short term if the interest rates go up. But over a longer period, the negative returns are ironed out as the funds continue to accrue coupons.

We would also recommend the investors that in the name of rebalancing, you should not get out of short to medium term funds at this juncture to invest in any target  maturity fund/ G-sec funds, if you are not sure that you will hold these funds till the end of the tenure (4 -10 years). A healthy fixed income portfolio should be a combination of short-and long-term bonds and funds with a focus to take care of any cashflow requirement in the short term and capital appreciation over the long term.

Happy investing!