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With interest rates rising, fixed-income instruments have become attractive. What are your options?

With interest rates rising, fixed-income instruments have become attractive. What are your options?

With interest rates rising, fixed-income instruments have suddenly become attractive. Take your pick from FDs, debt funds or corporate bonds

Not just corporate bonds, state bonds are also performing well. Not just corporate bonds, state bonds are also performing well.

The year 2022 has seen some unprecedented events. While the world was coming out of Covid-19-led disruptions, the commencement of the Russia-Ukraine conflict, coupled with other economic headwinds, led to a surge in commodity prices, further causing volatility in financial markets across the globe. Many developed countries have touched multi-decade-high inflation rates, forcing their central banks to go for inflation-targeting monetary policy, which has led to an aggressive rate hike cycle. Consequently, interest rates have shot up globally and most currencies have turned even more volatile. 

Back home, the situation is not very different. The Reserve Bank of India (RBI) has also increased the repo rate—the rate at which banks borrow from the central bank—four times since May 2022, and it is expected to further hike policy rates before taking a pause. Against this background, fixed deposit (FD) rates have gone up slightly. In such a scenario, the question arises: should one invest in FDs to cash in on the rising rates? Or are debt funds a better option with many of the view that interest rates are nearing their peak? Or is it better to invest in corporate bonds?

Let’s take a look at the state of different fixed-income segments and the strategy you should follow to get the maximum benefit.

Debt funds

Let us start with debt funds. The RBI has been increasing rates and reducing system liquidity over the past year, leading to yields rising across maturities. Sample this: In the past five months, the repo rate has been raised by 190 basis points (bps) to 5.9 per cent, while the benchmark 10-year G-sec yield has risen 160 bps to 7.4 per cent. Accordingly, over the past year, debt funds have not done well, as they saw the prices of their holdings going down; because, when interest rates rise, bond prices fall and since debt mutual funds (MFs) need to mark their net asset values (NAV) to the market daily, with the drop in bond prices, NAVs also suffer. “Debt funds have seen investors pulling out almost Rs 2 lakh crore this calendar year and the returns were mostly positive—3-4 per cent annualised,” says Sandeep Bagla, CEO of TRUST Mutual Fund.

So, is it a good time to invest in debt funds? “We are recommending investments into funds that have roll-down or portfolio maturity of two years or lesser. It is quite possible that inflation could remain stubborn and yields may remain higher for a long time. At this point, we would advise only a 5-10 per cent to longer-term funds, about 25 per cent to liquid/money market funds, and about 65 per cent to short-term funds or BPSU (banking and PSU) debt funds with roll-down maturity of lower than two years,” says Bagla.

Similarly, if you have a medium-term horizon (four-six years), don’t mind short-term fluctuations in returns and are looking at post-tax returns, then a class of debt funds, called Target Maturity Funds, score over FDs. “Target Maturity Funds offer yields (net YTM) in the range of 7-7.25 per cent over maturity of four to six years. They predominantly invest in government securities, PSU bonds and state development loans (SDLs), and the instruments are held till maturity of the scheme. They are a good investment option if one treats them like open ended fixed maturity plans (FMPs),” says Alok Agarwala, Chief Research Officer, Bajaj Capital Ltd.

Given that there are 16 Sebi-defined categories under debt funds, the easier way is to match your investment horizon to the average maturity of the scheme.

“Both debt MFs and FDs have some advantages as well as disadvantages over the other. Debt MFs carry interest rate risk which make them unattractive when interest rates rise. But they also have a lower risk of default, as they have a highly diversified portfolio. Plus, income tax on gains from debt MFs is materially lower compared to FDs,” says Agarwala.

The tax advantage also makes debt funds attractive. “When bond rates are rising faster than bank FD rates, investing in bond funds should give a portfolio yield higher than FDs. If an investor holds investment in MFs for more than three years, the investor would need to pay long-term capital gains (LTCG) tax with indexation benefit. Hence, the post-tax returns for debt MFs could be much higher than that of bank FDs, as there are no tax benefits for holding three-year deposits,” says Bagla.

Currently, it is advisable to lock your funds only in short maturity schemes, as inflation may remain high for a long time. However, one should always invest based on risk profile. For complete risk-free investment, FDs are certainly better. “For example, in FDs, whereas bank deposits carry a low interest rate of 5.45-6.10 per cent, certain AAA-rated corporate deposits carry a coupon of around 7 per cent or slightly higher, which, coupled with a lack of interest rate risk, makes them an attractive proposition,” says Agarwala. But, if one wants to leverage on interest rate movement then debt funds could be the choice.  

Corporate bonds

Now for corporate bonds. While investing in bonds directly, one needs to be mindful of the interest rate cycle and maturity of the securities, as interest rate and bond prices are inversely correlated. For example, if you hold a long-term bond with an interest rate of 10 per cent and the rate goes up to 12 per cent, the value of your bond will reduce. The change in the price of the bond is based on interest rate movement. The longer the duration of the bond, the higher the impact on the bond price. But, if you stay invested, at the end of the tenure you will get the coupon rate that was locked in at the time of buying the bonds.

Currently, with the rise in interest rates, corporate bonds are offering a much higher rate (up to 13 per cent) than FDs (5-6 per cent for a tenure of one-three years). “Corporate bonds in the fixed-income category are one of the best options to invest in. Currently... the top performing corporate bonds [are]... Muthoot Fincorp (subdebt) with yield of 10.50 per cent; Indiabulls Housing Finance Limited (unsecured) with yield of 14.25 per cent; and Piramal Capital & Housing Finance Limited (secured) with 11.4 per cent yield,” says Ankit Gupta, Founder of 

Other options

Not just corporate bonds, state bonds are also performing well. “On a 10-year paper, state bonds are offering approximately 7-8 per cent return, which is pretty decent compared to G-secs,” Gupta adds.

Though it is easy to get swayed by the high interest rates, note that this instrument comes with high credit risk. Hence, while investing in corporate FDs and bonds, one must check the credit quality of the issuer and also diversify the investments uniformly across at least four to five issuers. “Never put all your money in bonds or FDs of a single issuer or companies from a single sector. Given the current macroeconomic backdrop, one should invest only in highest rated bonds or FDs, even if it means sacrificing some returns,” says Agarwala.

Then there are other secured options available such as Floating Rate Savings Bonds of the RBI where the return does not vary with the interest rate movement; they are issued by the Indian government. Here investors can purchase the Floating Rate Savings Bonds 2022 with an interest rate of 7.15 per cent—35 bps higher than the rate offered on the National Savings Certificate, and there is no upper limit on investment. But, there is a lock-in period of seven years and the interest rate is announced in advance every quarter for these bonds.  

For senior citizens, there are more options such as Senior Citizens Savings Scheme (SCSS) offering 7.6 per cent and Pradhan Mantri Vaya Vandana Yojana (PMVVY), a retirement scheme. PMVVY pays out a pension at the assured rate of 7.4 per cent. The scheme is for a fixed period of 10 years. One can invest up to Rs 15 lakh in the policy for a monthly pension of Rs 9,250.  

Repo rates have risen significantly since they hit the bottom (4 per cent) in April 2020. By carefully diversifying your fixed income portfolio, you can earn higher returns. But always remember higher returns come with higher risks.