In the current fixed income market, the return across the curve is lower than the bottom and the return curve is steep. According to Bloomberg on January 4, ’22 the prevailing term yield for AAA PSU bonds is 4.66% for one year, 5.57% for three years, 6.16% for five years and 7.03% for ten years.
As rates move up, the yield curve is expected to flatten, meaning that the shorter end of the curve (1-3 years) is expected to rise faster than the longer term (10 years).
During the IL&FS crisis in November 2018, the yield curve was flat and the returns were very high. For example, the one-year AAA yield and the 10-year AAA yield were both at 8.8%.
Before the pandemic, a simple strategy of holding a debt fund of AAA and underlying credit quality with maturities of three years would have been enough to beat retail inflation, which typically averages 6% per annum in India.
However, with current yields so low, this strategy needs to be changed completely.
Short maturity funds are not sufficient to beat inflation, whereas only long term funds (maturity of 10 years) have high interest rate sensitivity and are subject to high volatility.
A ‘barbell’ fixed income investment strategy involves building a portfolio with a combination of short term debt instruments and long term debt instruments to achieve the optimum mix of yield and duration (interest rate sensitivity).
In today’s context, we suggest building an iron portfolio where (i) 65-70% should be invested in AAA-oriented roll-down strategy funds with a maturity of 3-5 years, where returns are 5.50-6.00 % p.a., and (ii) the remaining 30-35% can be invested in AAA-oriented roll-down strategy fund with a maturity of 10 years, where the return is close to 7% p.a.
This would effectively provide a portfolio where the weighted average maturity profile is around 5.5 years (ie ~4 year duration), and significantly the return could be a little over 6% p.a.
Also, roll-down strategies will ensure that the interest rate sensitivity or duration of the portfolio keeps on reducing with each passing year.
Passive roll-down debt funds, such as Bharat Bond Fund, PSU Bond Plus SDL Fund, are best suited to have such an iron portfolio strategy as their portfolio consists of only AAA-rated instruments and State Development Debt (SDL), the latter It is on par with government debt when it comes to sovereign debt.
Note that this strategy is recommended for investors who have a minimum investment horizon of three years. Debt funds need to be held for three years to qualify for long term capital gains tax at 20% with indexation benefit.
(Nitin Shanbhag is Head of Investment Products at Motilal Oswal Wealth.)
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