Debt plays an important role in a portfolio. It can act as a cushion in periods of significant market volatility, holding steady or falling substantially lesser than equity (e.g., 2008-09, early 2020, etc.), generate regular income, and provide attractive investment opportunities, particularly when real interest rates are above long-term averages.
As widely expected, if the RBI continues to hike rates further, it is likely that yields on short term bonds would move up more than those on longer tenor bonds, which have already risen in anticipation of further rate hikes.
As a debt investor, one can stagger their investments (vis-à-vis investing in lumpsum) into fixed deposits or individual bonds at current rates as these might go up further. For investors in debt mutual funds with a horizon of 3 years and above, around 40-50% of the corpus can be invested in funds with a portfolio duration of 1 to 3 years such as Banking & PSU Funds and Corporate bond funds, where the impact of interest rate increases on overall return would be limited due to the low duration. Around 10%-20% can be parked in Liquid or Ultra-Short Term Funds with a duration of less than 1-year; yields on these funds would start rising now and the impact of rate increases on underlying bond prices and overall return would be minimal. As yields on Banking & PSU debt or Credit Risk Funds increase, one could move the liquid fund investments to these categories.
Given the attractive spreads in the medium to long duration of the G-Sec yield curve (5 to 10 years), one could invest around 25%-35% in medium to long duration debt funds or dynamic bond funds, particularly those holding G-Secs. One can also consider passive or roll-down index funds which invest in G-Secs, say with a residual maturity of 5 to 7 years, and hold them till maturity. Due to higher term spreads, these securities are trading at attractive yields, providing better accrual, and expense ratios for roll-down funds are lower than actively managed funds.
Dynamic Bond Funds can be quite volatile in the current environment. I am currently not recommending Dynamic Bond Funds. These funds are akin to Flexi Cap Funds. However, to flex and manoeuvre in different debt instruments across the yield curve can be way more difficult and complicated. Liquidity can be a big issue and is immensely important in the debt market. Lack of liquidity in the corporate bond market can limit the flexibility of these funds. This can have a huge impact on the fund and its net asset value or NAV. In the current volatile and rising yield scenario, my view is that it is better to stick with simple accrual/roll down/target maturity funds somewhere at the shorter end of the yield curve to minimize drastic downside mark to market hit.
Over the past six months wherein shorter-term yields have risen sharply compared to the longer-term yields, floating rate funds have fared better than the Dynamic bond fund category (as of June 03, 2022), and have also outperformed shorter-duration categories such as banking & PSU debt fund, corporate bond fund and short-duration funds. However, dynamic bond funds can form a part of the satellite (non-core) portion of the portfolio if your investment horizon is reasonably long (5+ years) as these funds can be expected to do well over a complete interest rate cycle.
Debt investors can check out these articles
