Build debt
fund portfolio diversified across duration
Take limited
exposure to longer-duration funds in coming year
Debt mutual
funds turned in a strong performance in 2024, with longer-duration funds
leading the way. In 2025, while rate cuts may begin, the cycle is likely to be
a truncated one.
Experts
suggest not going overboard on longer-duration funds and instead building a
portfolio diversified across duration.
Drivers of
performance in 2024
Both
dropping bond yields and high accruals contributed to performance. The yield of
the 10-years benchmark government security (G-Sec) dropped from around 7.2 per
cent to around 6.8 per cent, creating market gains. In addition, reasonable
accrual levels also supported the performance of debt funds.
The global
environment was also conducive. The decline in global inflation, receding from
post-Covid highs, created an environment where long-term interest rates dropped
in anticipation of central banks’ cuts.
Tight
liquidity led to higher short-term rates. Overnight rates have been around
6.5-6.75 per cent, as system liquidity has been mostly in deficit. Short-term
instruments like the 3-month commercial paper and certificates of deposit yielded
close to 7 per cent, leading to high average returns in liquid and money market
funds.
Inclusion in
overseas bond indexes also played a part. The inclusion of Indian bonds in JP
Morgan indices, which brought around Rs 1 trillion in inflows drove performance.
Maintain
allocation to debt
Investors
must maintain some allocation to debt funds in 2025. They can serve as a
defensive asset class amid high equity valuations. Debt funds provide
flexibility to rebalance one’s portfolio during equity market corrections. For
short-term goals, debt continues to be the most appropriate asset class.
Positive
drivers
The Reserve
Bank of India (RBI) recently shifted to a neutral stance and cut the cash
reserve ratio (CRR). Experts believe that a rate-cutting cycle by the central
bank in 2025 can significantly influence fixed-income performance.
The RBI to
cut rates to stimulate growth, which will be positive for fixed income.
A 50-basis
point rate cut in the next six months owing to slowing GDP growth. Further
fiscal consolidation by the government, with an anticipated fiscal deficit
below 4.5 per cent for FY26, will lead to strong bond demand-supply dynamics.
Negative
factors
Geopolitical
factors could impact returns of debt funds. Geopolitical instability, higher
inflation and fiscal deficit due to tariff increases, and debt scare in the US
is a possibility.
Global
central bankers, while reducing the cost of money, are simultaneously shrinking
the size of their balance sheets. Diminished global liquidity can adversely
affect sentiment.
The rupee
depreciates significantly, the RBI may slow the pace of rate cuts to avoid
unnecessary depreciation.
Tilt towards
longer-duration funds?
Tilting one’s
portfolio towards longer-duration funds may not be advisable in 2025. RBI to
cut rates in February 2025, but it is likely to be a shallow rate-cut cycle,
with 50-75 basis points cut in 2025. Longer-term bonds do not appear to have
much room for appreciation as inflation expectations are still not firmly
anchored. Moreover, a part of the bond rally has already taken place in
anticipation of cuts.
Investors
looking to buy longer-duration funds need to be mindful of potential
volatility. Significant capital appreciation unless growth slows down rapidly.
Diversify
across duration
Instead of
chasing past year’s performers, pay heed to your investment horizon. Choose a
fund whose portfolio maturity matches your investment horizon. For instance, if
the maturity is three years, the horizon should be at least two years or more. Avoid
investing in longer-duration funds for a short horizon.
Build portfolio
diversified across duration. Allocate 30 per cent to longer-duration funds and
70 per cent to low and short-duration funds. Avoid over-allocating to one type
of fund. Investors move out of longer-duration funds after the initial rate
cuts. In 2025, inflation is likely to be under control but growth may weaken. Allocation
to dynamic bond funds, and short to medium term funds, including corporate
funds, can help capture the interest rate cycle. Investing in dynamic bond
funds allows investors to play all parts of the rate cycle.
Do’s and don’ts
Be prepared
for some volatility in your fixed-income portfolio. Keep an eye on the US Federal
Reserve’s monetary policy actions, the rupee’s behavior against the dollar and
other currencies, and the new US President’s policies.
Think twice
before taking credit risk. Lower-rated bonds may not be as liquid and may also
carry higher default risk.
For More Details: Pooja Manoj Gupta, visit www.giia26.com
Email: pmgiia26.com Mobile 9868944340
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