For the past two to three quarters, the debt market has been more volatile than equity, but for the recent equity market correction in February.

We are all familiar with the concept of SIP, all the more so after the Mutual Fund Sahi Hai campaign. But whenever we think of systematic investment plan, we think about equities. The reason is, equity market is relatively more volatile than debt and the concept of purchase cost averaging is applicable more to equities. If the market level comes down, you benefit by purchasing at a lower level which you may not have done but for the discipline of SIP.

What we are discussing here is, SIP in debt. Sounds uncanny?

The logic

For the past two to three quarters, the debt market has been more volatile than equity, but for the recent equity market correction in February. There were quite a few negatives, already discussed in the media many times earlier, which were discounted by the market as yield levels went up. In hindsight, it would have been better to book out of long-term bond funds and move into short-term bond funds, sometime in the middle of previous year. That being history, what now?

One approach now could be to put the debt allocation of the portfolio in shorter maturity funds, so that the impact of market volatility is that much lower. This is a safe strategy. The other possible course of action, for investors with a higher risk appetite, for a component of the fixed income portfolio, is to take a calculated risk into long maturity bond funds. The rationale is, the spread between the overnight repo rate of 6% and the 10-year benchmark Government Security (G-Sec) yield of approx. 7.7% is at 1.7%. This is one of the highest, going by history.

This kind of spread has only two parallels in recent history of the bond market. One is in 2013, when the RBI took the unprecedented measure of steep hike in interest rates, purportedly to incentivise FIIs to buy Indian debt and support the INR. That measure did not work but our markets and investors took an unnecessary hit. The other instance was in 2009 after the global financial crisis, when the liquidity infusion of the RBI was absorbed by the market and yields went up in apprehension of high fiscal deficit and large additional government borrowings. In the previous two occasions, there was a fundamental alarm, leading to high G-Sec yields.

This time, there is no fundamental crisis. Potential negatives like little higher inflation or crude oil price have been discounted by the market. The fact that globally interest rates and liquidity infusion is on the way out is also known to the market. The RBI has changed policy rate stance to neutral with a hawkish bias, but it is still some time for rates hikes to come. Core inflation is still in a manageable range. The only apprehension remaining in the market is the hard stance taken by the RBI on risk management of banks and the absence of PSU banks in the market. It is a cause for concern that as and when the government borrowing program starts from April, in the absence of PSU Banks, G-Sec yields may move up further. By that time, something may be worked out by the RBI.

That being the case, why not take a calculated bet, for a component of the fixed income allocation, into long term bond funds? If the current yield level is attractive and may potentially become more attractive over the next few months, though at the cost of the existing allocation, it is time to add more. It is preferable to have a horizon of 3 years or longer, since a long horizon is advisable, and to avail of tax efficiency.

Risk and reward

If you stay in shorter maturity funds, you will be limiting the volatility in your portfolio. Coming to long maturity funds, at the cost of higher volatility in your portfolio, is justified when there is reasonable spread i.e. long term bonds have a higher yield than money market instruments. In June 2017, the 10-year benchmark yield was approx. 6.5% and the overnight repo rate was 6.25% i.e. the spread was only 25 basis points. From that perspective, today’s spread of 1.7% is remarkably attractive. The risks are, (a) if banking system liquidity, which has moved from surplus to neutral zone, tightens for some time and (b) the sizable government borrowing program of approximately Rs 10 lakh crore including State Loans, faces hurdles due to RBI’s hard stance. Though it is hazardous to call market levels, we are near to bottoming out in the government bond market. Through the discipline of SIP, you will be adding more at regular intervals.

Conclusion

For the relatively adventurous fixed income investor, it is time to take a call. At the current levels, the market has discounted most of the negatives.

Source: https://www.moneycontrol.com/news/opinion/sip-in-debt-funds-an-idea-worth-exploring-2520369.html