With the interest rate hike cycle by RBI at its fag end, discussions in the market on the case for investing in long-maturity funds are picking up, but it’s advisable to wait for better visibility.
One of the basic theories of money management is the time value of money. The longer you spare your money, the higher should be the rate of compensation, known as interest or coupon. When the yield curve is flat, you get similar or marginally higher rewards for investing your money for longer periods. While you get an interest or coupon for as many years, the rate remains similar in a flat curve. Currently, the yield curves are flat.
There are multiple yield curves. The most relevant ones are government securities (G-Secs), which are yields on bonds issued by the government. The other is corporate bonds. The yield levels (the effective annualised return you get by investing) of corporate bonds are, in a way, based on the G-Secs curve, which is the most liquid and is of prime importance. Corporate bond yield curves are classified as per credit rating, such as AAA, AA, etc.
You can construct your fixed-income portfolio by either purchasing bonds or going through investment vehicles like mutual funds (MFs). Bonds are of multiple types, such as G-Secs, where you can participate through the Reserve Bank of India’s (RBI) Retail Direct Gilt system. You can buy corporate bonds through trading accounts with broking houses, and non-banking financial companies (NBFCs) specialising in bonds. Corporate bonds include tax-free public sector undertaking (PSU) bonds, taxable PSU and private sector bonds, etc. PSU and private sector bonds are classified as per credit rating, such as AAA, AA, etc. In MFs, there are multiple fund categories classified as per portfolio maturity and, to a limited on credit rating. In bonds or bond funds, the higher you go on maturity, the higher the gains or losses on the market movement of interest rates. So, shorter-maturity bonds or bond funds are relatively more stable in performance.
As mentioned, yield curves are flat. If you buy a bond of, say, five-year maturity as against a bond of, say, one-year maturity, you will get a marginally higher yield. Or if you buy a 10-year bond vis-a-vis a five-year bond, you will get only a marginally higher yield. This scenario does not make a compelling case to purchase longer-maturity bonds. The reason it is being discussed in market and investor circles is that the Reserve Bank of India (RBI) is almost done with the rate hike cycle. The repo rate, which was 4 per cent after rate cuts during the pandemic, has moved up to 6.5 per cent. There is an outside chance of another rate hike in the next policy review on April 6, 2023. If that happens, that should be the last in this rate hike cycle.
With rate hikes almost done, people are looking at the case of rate cuts in the future. Inflation is expected to be stable going forward, and sometime in the future, there will be a case for easing policy rates. Given that longer-maturity bonds and bond funds gain more when interest rates fall, this is a point of discussion.
There is no major risk in taking a duration call, which is buying longer-maturity bonds and bond funds, as RBI is mostly done with rate hikes. However, if the rate cut(s) does not happen, your accrual or interest income would not be much higher than shorter maturity ones. Hence, there is no compelling case. Rather, if yields in the market increase for reason such as inflation giving a negative surprise, longer-maturity products would be impacted more.
It is advisable to match your investment horizon with the maturity of your bond or bond fund. If your investment horizon is three years, which is required for tax efficiency in debt MFs, you should invest in a fund with a portfolio maturity of three or four years.
There is no issue in investing in longer-maturity products, as RBI rate hikes are almost over. However, you face higher volatility risk and have to wait for RBI rate cuts for them to outperform shorter maturity products.
Historical data shows that long-maturity funds provide decent returns over a long holding period, even after all the fluctuations. Hence, if you have a horizon of, say, 10 years, you can invest in long-maturity G-Sec funds. Otherwise, go for target maturity funds, where allow you to seamlessly match your investment horizon. Sometimes, when there is better visibility of the interest rate cycle reversing, there is a stronger case for longer-maturity fixed income products.