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Investment strategy for debt investors as inflation fears rise

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NEW DELHI: Given the expectation of rising interest rates and subsequent policy normalisation by the Reserve Bank of India (RBI), experts suggest that investors should focus on shorter-maturity funds that see lesser impact when yields rise.

The consumer price index (CPI) inflation for May surged to 6.3% on a year-on-year basis. The headline inflation is now expected to average around 6% in FY22, against earlier forecasts of around 5.1%.

“This has changed the market expectation of the policy normalisation timeline. With acceleration in inflation momentum, RBI may start policy normalization sooner than later. It may withdraw the excess liquidity first and then move to rate hikes,” said Pankaj Pathak, fund manager-fixed income, Quantum Asset Management Company Pvt. Ltd.

Reacting to the rise in inflation, bond yields have moved up 10-20 basis points across the curve except for the 10-year benchmark bond that has risen four basis points. The 10-year benchmark G-Sec was trading 1.3% higher at 6.17% on Tuesday.

According to the fund house, RBI’s tactical interventions and committed bond purchases under the government securities acquisition program (GSAP) will continue to support the bond market in the near term. “However, the macro backdrop has turned adverse for the bond market,” it said.

The AMC is of the opinion that inflation and monetary policy normalisation will play a bigger role in shaping the interest rate trajectory over the medium term.

“We also argue that bond yields have already bottomed out in this cycle and are likely to move higher over the next two-three years, given the expectation of rising interest rates, it would be prudent for investors to focus on shorter-maturity funds that impact less when yields rise,” said Pathak.

Investors should note that bond prices and debt funds’ net asset value (NAV) fall when market yields move up.

The fund house also suggests that conservative investors should stick to very short maturity debt categories such as liquid funds and investors with a longer holding period and an appetite to tolerate intermittent volatility could consider dynamic bond funds.

“We also suggest investors lower their return expectation from debt funds as the potential for capital gains will be limited going forward,” the fund house said in a note.

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