How should you re-position your portfolio when interest rates are rising?

The period of easy and cheap money that seemed to be the norm for last 10 years is getting over now. The central banks of the world over have stepped up their tightening monetary policy rhetoric. This is clearly visible in the hardening of the bond yields globally. India following the suit has seen its 10-year government bond yields increased by 80 basis points in the last one year. As bond prices and yields are inversely related, rising-yield mean lower bond prices and MTM (Mark to market) losses leading to lower returns. In last one month and three-month time horizon almost, all debt funds including gilt and dynamic bond funds have generated negative returns.

In this situation when the interest rates are rising, how should you position your debt portfolio? In this situation floating rate bonds (FRB) act as a good hedge, as bond prices move higher with rising interest rate. Since FRBs have a coupon reset every six months, mark-to-market loss doesn’t arise. However, the only problem is that floating rate bonds are not issued easily as adverse yield movement would mean the government would have to pay a higher coupon each time. Hence, you are left with few options to manage rising bond yields.

The best way to protect your debt part of the portfolio is to move your funds to take exposure in a mix of low duration and short-term funds. As these are less likely to get impacted by rising interest rate. In case of the equity portfolio, during rising interest rates, ‘cyclical’ stocks such as industrials, finance, etc. have historically done better whereas ‘defensive’ such as consumer staples, healthcare etc, have been a poor performer.

Therefore, as an investor, you can make a portfolio of lowly correlated investments including short-term debt funds and cyclical stocks that will enhance your returns at current juncture without increasing risk in the same proportion.