How to Maximize Debt Portfolio Returns
In today’s fixed income market, yields across the curve have bottomed and the yield curve is extremely steep. The forward yields in effect for AAA PSU bonds as of Jan. 4, 22 according to Bloomberg are 4.66% for one year, 5.57% for three years, 6.16% for five years and 7.03% for ten years.
As rates rise, the yield curve should flatten, meaning that the shorter end of the curve (1-3 years) should rise faster than longer terms (10 years).
During the IL&FS crisis in November 2018, the yield curve was flat and yields were much higher. For example, the one-year AAA yield and the 10-year AAA yield were both 8.8%.
Before the pandemic, a simple strategy of holding a debt fund with an underlying AAA credit quality and a three-year maturity would have been enough to beat retail price inflation, which typically averages 6%. per year in India.
However, with the current returns being so low, this strategy needs a complete overhaul.
Short-term funds are not enough to beat inflation, while having only long-term funds (10-year term) poses a high sensitivity to interest rates and is subject to high volatility.
A âBarbellâ fixed income investment strategy consists of creating a portfolio with a combination of short-term debt instruments and long-term debt instruments to achieve an optimal combination of yield and duration (sensitivity to interest rates). of interest).
In the current context, we suggest creating a dumbbell portfolio in which (i) 65-70% should be invested in AAA oriented roll-down strategy funds with a maturity of 3 to 5 years where the returns are between 5.50 and 6.00% pa, and (ii) the remaining 30-35% can be invested in AAA oriented roll-down strategy funds with a maturity of 10 years where the returns are closer to 7% pa
This would effectively provide a portfolio with a weighted average maturity profile of around 5.5 years (i.e. a duration of around 4 years), and above all the yield could be slightly above 6% per year. .
At the same time, roll-down strategies would ensure that the sensitivity to interest rates or the duration of the portfolio continues to decrease year on year.
Passive debt roll-down funds e.g. Bharat Bond funds, PSU Bond plus SDL funds are best suited to build such a dumbbell portfolio strategy as their portfolios consist only of AAA rated instruments and State Development Loans (SDLs), the latter at par with G-secs when it comes to sovereign credit.
Note that this strategy is suggested for investors with a minimum investment horizon of three years. Debt funds must be held for three years to be eligible for long-term capital gains tax at 20% with an indexation benefit.
(Nitin Shanbhag is Head of Investment Products at Motilal Oswal Wealth.)
Never miss a story! Stay connected and informed with Mint. Download our app now !!