Following RBI Policy, mutual funds reiterate appeal of 5-7 year ‘sweet spot’

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In their reactions to the RBI Monetary Policy announced today, mutual fund houses have reiterated their positive stance on debt funds investing in the 5-7 year bonds. Some fund houses launched a series of funds with this type of maturity last month as Mint has reported (Passive investing gathers pace in the debt mutual funds space). They have reiterated the attractiveness of this maturity.

The yield on debt paper increases as its maturity goes up. For example, if a 1 year treasury bill fetches 4%, a 5 year government bond might fetch 5.5%. This extra yield is offered to investors to compensate for the higher risk of holding long maturity paper. Investing in such a higher yielding paper can enhance your return. However if interest rates rise, these longer maturity papers see a greater loss of value. Thus a key question for investors is whether the additional yields compensate for this risk of rates rising.

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“The central bank has delivered on most of what bond market participants may have reasonably asked for given the circumstances. The yield curve is very steep even at intermediate duration points (5–6 years) thereby providing strong compensation for holding bonds as against cash,” said Suyash Choudary, head, fixed income, IDFC Mutual Fund in a note released to investors today.

“Investors should expect low single-digit return from the bond market in FY22 and will have to increase their average maturity to optimize their risk-adjusted returns. We wish to highlight that investors at the short-end (up to 2Y) will probably earn zero or negative real return (inflation-adjusted) in FY22, similar to FY21,” said a note issued by Dhawal Dalal, chief investment officer, fixed income, of Edelweiss Mutual Fund. “Prudent investors are requested to consider investing in high-quality bonds maturing in 5Y or higher through passively-managed target maturity bond index funds as well as bond ETFs to benefit from diversification, transparency, simple and clear investment objectives, and predictability of returns for hold-to-maturity investors in our opinion,” he added. “The current yield curve is quite steep till 5–7 years and then the additional duration risk taken may start overwhelming the additional carry on offer, in our view. Hence, our preference in our active duration mandate remains currently best expressed as an overweight in the 5–6 year part of the government bond curve; with the usual caveats on flexibility,” said Choudary.

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