Stick largely to accrual funds despite softening of 10-yr govt bond yield

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As was widely expected, the Monetary Policy Committee decided to keep interest rates unchanged. But, the lowering of the inflation estimate for 2018-19 did surprise many. The benchmark 10-year government bond yield, which had risen to 7.78 per cent in the recent past, had softened to around 7.3 per cent after the government announced that it would borrow less in the first half of the financial year. After the monetary policy, it fell further to 7.13 per cent, following the Reserve Bank of India’s (RBI’s) dovish outlook on inflation. 

Economists expect an extended pause. “With inflation estimated to be in no man’s land — neither too high, nor too low — the RBI will remain on extended pause,” says Suvodeep Rakshit, senior economist, Kotak Institutional Equities. The risk from inflation, however, remains. Risks could arise from hardening food prices following the revision in formula for determining minimum support price (MSP), a poor southwest monsoon, fiscal slippage, domestic growth recovery, and global factors like faster-than-expected rate hikes in the US and further hardening of crude prices. Garima Kapoor, economist at Elara Capital, expects headline consumer price index (CPI)-based inflation to overshoot the RBI's forecast, resulting in one rate hike of 25 basis points in the second half of 2018-19. 

Retail investors should remain invested largely in short-term and accrual-oriented funds. "Even though the yield on the 10-year government bond has eased, and you may have seen some capital appreciation in duration funds, nonetheless do not increase exposure to duration strategies. Any move into such funds at this point would be risky. The accrual space remains attractive as yields have moved up over the past year or so," says Vidya Bala, head of research, An accrual-oriented fund is one that does not take large-duration calls but relies on the interest income from bonds. If it is a short-term fund, its average maturity will fluctuate between 1.5 and 2.5 years, and if it is a medium-term fund, it will fluctuate between 2.5 and 5 years. Such a fund also invests more in corporate bonds of double-A and triple-A quality than in gilts. 

As for dynamic bond funds, stay invested if you have already invested in them. Investors have suffered some pain over the past few months in these funds as interest rates rose. Most managers of dynamic bond funds have reduced the average maturities of their funds. They have also moved from gilt into double-A and triple-A corporate bonds. In other words, they are also mimicking accrual strategies currently. So, the kind of volatility that was seen in these funds in the past is unlikely to be repeated. The returns from these funds over a three-year period are also likely to be more normalised in the future, closer to those offered by an accrual fund. If you are putting in fresh money, avoid these funds and stick to accrual-oriented funds. If you want to invest in a long-term portfolio, say, for retirement, then in the debt portion of such a portfolio you may invest largely in short-term funds, some amount in medium-term income funds, and a small portion (5  per cent) in a long-term income fund. “If interest rates decline over the long term, you will enjoy capital gains, though they will be volatile in the interim,” says Srivastava.