The short end of the yield curve based on short-term interest rates is determined by liquidity scenario and expectations from the RBI Monetary policy- rising when RBI is expected to raise rates and falling when interest rates are expected to be cut. The long end of the yield curve is influenced by factors such as inflation expectations, macro factors. Demand and supply of securities is another factor affecting interest rates.
From the portfolio management perspective
There are multiple factors playing simultaneously and adding complexities in practical, however for explanation sake, let’s look at Fixed Income from portfolio management perspective –
Where in the interest rate cycle are we-
If the house view is that we are at the end of rate hike cycle, in that moment flat yield curve, shifting down of yield curve would be the expectation ahead. High duration positioning would be taken to benefit the most in anticipation of future or upcoming rate cuts. If it is viewed that we are at the end of the rate cut cycle in that moment, steep yield curve – shifting up of the yield curve would be the expectation ahead. Lower duration positioning would be taken to protect the portfolio most in anticipation of future or upcoming rate hikes.
Whether the yield curve is expected to steepen or flatten post the shifting and how-
If the house view is that the yield curve would steepen with short end coming down faster than the long end or long end rising faster than the short end, then the portfolio manager would slide down the maturities on the yield curve, yields of those maturities which are expected to fall the most. If the house view is that the yield curve would flatten by short end rising faster than the long end, or long end falling faster than the short end, the portfolio manager would be constructive on relatively higher maturities, yields of those maturities which are expected to fall the most.
What does demand supply equation look like to assess what is priced in and the expected price movements ahead-
Whether banks, insurance companies and Mutual funds are buying and into which maturities, as stronger demand would push up prices. Whether govt and corporates are borrowing as numerous issuances will lead to more supply and push down prices.
Whether spreads are expected to widen or compress at respective maturities – AAA over Gsec, AAA over PSU, AA over AAA-
If spreads are expected to widen in the 3 year maturity bucket, by either
- G sec yields coming down faster than corporate bonds and corporate bond yields hardening OR
- Corporate Bond yield hardening while G sec holding / slightly falling
– then the call would be to overweight Gsecs on 3-year maturity.
If spread compression is expected for say 5-year maturity bucket, by either
- Corp Bond yield coming down faster than the Gsec and Gsec yield hardening OR
- Corp Bond yield holding /falling slightly while G sec yields harden,
– then the call would be to overweight corporate bonds on 5-year maturity.
From the Investor’s lens
Coming to how an investor would think Fixed Income taking the view that we seem to be close to the end of rate hike cycle –
If the investor has no horizon constraint and can ride through volatility, long duration funds like gilt funds are good to hold. Long duration funds would capture shifts down of the Gsec yield curve, change in shape of the yield curve vide being very active on trading strategy and thus high on volatility.
If the client does not wish to have very high volatility, BPSU Debt funds and Corporate Bond funds can be recommended. These funds would be suitable with a horizon of 1 to 3 years. Short duration funds, BPSU debt funds and corporate bond fund category is targeting to capture more of changing shape of the PSU and AAA corp bond, vide 70-75% accrual strategy, 20-25% in Gsecs and thus medium volatility. Beyond 3 to 4 years maturity, availability of high tenor bank, PSU and AAA Corp Bond papers is a challenge. In the corporate bond yield curve case, the fund manager would find it difficult to ride the shift down of the yield curve by running a 7 to 8 years duration followed by capturing change in the shape of the corp bond curve. This is as portfolio changes cannot be swift and immediate for large amounts of AUM due to lesser liquidity in corporate bonds as compared to Gsecs. Thus, it is better to position the fund in those corporate bond maturities which are priced the best currently or yields of which are expected to fall the most.
Very short end funds are suitable for the horizon of 1 month to 1 year. Ultra-short-term funds, Low duration funds and money market funds look at the segment which are priced better. They would assess from where the performance or mark to market gain would get generated (3 months, 6 months, 9 months, 12 months) and accordingly position his portfolio. The fund manager might not necessarily be positioned at the highest current YTM but would be positioned at an optimum place with respect to YTM and expected future mark to market gains, while being sensitive to monthly return.
Target maturity funds or FMPs suit Investors who wish to have a relative certainty of returns and have a horizon matching with tenor of the respective product, though target maturity funds are open ended by structure while FMPs are close ended.
The role of debt in an investor’s portfolio is two-fold – certain short-term goals can be better achieved by investing in fixed income funds, like creation of emergency funds, temporary parking of funds or catering to near term goals of 2-3 years. The nature of income in case of these is more regular savings or Income oriented. Investing in debt funds for more than 3 years would be for earning capital gains while providing stability to the overall portfolio encompassing other asset classes.
By Shaily Gang, Head – Products, Tata Asset Management Pvt. Ltd
Disclaimer: The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. The views expressed are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Asset Management Pvt. Ltd. will not be liable in any manner for the consequences of such action taken by you. Please consult your Mutual Fund Distributor before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund. The view expressed are based on the current market scenario and the same is subject to change. There are no guaranteed or assured returns under any of the scheme of Tata mutual Fund.
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