Best investment options for fixed income investors

Fixed income markets had been dicey due to two major things i.e. falling interest rates and rising credit risk. Now the question is, in such a scenario, where should the fixed income investors place their bets on? In this article, we would explain a few things that a fixed income investor must understand before investing.

A declining trend in interest rates

The interest rates of the key products like employees’ provident fund (EPF) and small savings schemes, such as public provident fund (PPF), post office savings, national savings certificate, and bank deposit rates have all been declining since the past few years.

A one-year bank fixed deposit (FD), which used to fetch 9 per cent in the year 2013 on an average, now fetches almost 4.50 per cent to 5 per cent. Similarly, PPF, which used to give 8.80 per cent in 2013, now offers not more than 7 per cent. Furthermore, the savings bank account rates offer 2.5 per cent, which is lower than the consumer price index (CPI). Presently, bank deposits are generating negative real rates of return. Even the yields on government securities have witnessed a steady decline from 8.15 per cent in October 2018 to 6 per cent in October 2020, declining by almost 2.25 per cent.

Wider spreads

Currently, the operative rate (reverse repo) is at its historical low of 3.35 per cent. The yields on 10-year benchmark bonds are near about 6 per cent. This means a spread of nearly 2.60 per cent (260 basis points), which is at a historical high, makes long-duration bonds highly attractive.

Having said, volatility comes as a complementary with long-term bonds, provided, there's a movement in interest rates. Such spreads seem to be quite attractive provided that there is an extremely weak growth environment, Reserve Bank of India’s (RBI) liquidity flush and maintenance of accommodative stance as well as the possibility of moderate inflation in the medium-term.

Buoyant yield outlook

The newly-formed Monetary Policy Committee (MPC) has started to focus on growth, which is on the top of its priority list. Also, it has shown its willingness to shrug high inflation for the time being. In order to promote growth, it is likely to keep interest rates low.

Though it seems that we may have witnessed the best part of the rate cuts, yields can still move lower even without any rate cuts, provided the existing spreads over the reverse repo and repo rates. Having said, another rate cut cannot be ruled out, if in case, growth fails to take off in the next six months.

Therefore, it would be prudent for fixed-income investors to re-position their portfolios by investing mutual funds in medium-term bonds. This means that their Macaulay duration should be between 3 years and 7 years. This is because, presently, they are enjoying almost 2 per cent to 2.5 per cent spread over reverse repo rates. Hence, investing in short duration funds, medium duration funds, corporate bond funds, and banking & PSU debt funds would be a wise choice.