Rising Yields with Normalization…

As far as surplus liquidity is concerned, the normalization process has accelerated in the US with the Fed initiating the tapering of bond purchases by US$ 15 billion. This amount has been subsequently enhanced to US $30 billion due to high inflation. In India, the RBI intensified the process of liquidity normalization by announcing Variable Rate Reverse Repos to the tune of Rs.7.50 lakh Crs by Dec 31, 2021. The liquidity withdrawal will result in pressure on very short- term rates in the immediate future and this will have consequences for long end rates too. Inflation remains elevated though not as high as it was three months back. But there may be concerns of higher price level due to the potential for oil prices to move up and also due to a weaker Rupee, apart from the tendency for many domestic articles of consumption including fruits and vegetables and protein foods to become more expensive. While accommodative stance may continue for an extended period of time, the market rates may move up in anticipation of tighter monetary policy and rate action in future. In view of this the product preferences at this juncture should reflect three things: (i) the expected rise in interest rates across maturities, (ii) minimize the loss of value to the lowest level possible, (iii) ensuring the credit quality of the portfolio to be of a high order, and (iii) generating a return comparable with the benchmark returns.

High Accrual Portfolios – One of the sensible things to do in a rising interest rate scenario is to invest into high accrual funds. High accrual will enable the portfolio to overcome the depreciation on account of rising yields to a large extent. This is because the rate depreciation has to move up consistently above the rate of accrual for the portfolio to register a depreciation. Therefore, accrual portfolios are preferred. At the same time, the credit quality of the portfolio should not be compromised as credit events may rise sometimes with rising cost of funds. Arbitrage Funds – Arbitrage funds are preferred for their stable returns and tax efficiency over the fixed income funds. For investments of short- term surplus of three to six months duration arbitrage funds would be an ideal destination. Fund Concentration in Shorter Maturity – To reduce the price risk or interest rate risk, the primary consideration in investments is to invest into short maturity products. While this strategy generally works well, there is yet another factor that needs to be kept in mind. The secret lies in identifying those funds which have a higher concentration of the portfolio holdings with maturity within the next one year. If a significant portion of the maturities is within six months or one year, then it gives the portfolio manager the opportunity to pick up fresh investments in papers whose yield will be on the then prevailing yield curve. In other words, the re-investment will be at higher rates for this part of the portfolio. This will help push up the portfolio yield, and thereby, the portfolio returns. Direct Bonds – Bonds at attractive yields and acceptable credit ratings could be picked up for the portfolio but which have a maturity profile of 2 to 3 years. In recent times, the offers on some of the state government enterprises have come at relatively higher yields. Dismayed by the lower returns from normal debt products, it is likely that the lure of higher yields for a lower credit may look tempting, a feeling that should overcome with stronger resolution mainly because as rates rise and liquidity dwindles, many companies may face pressure emanating from higher cost of debt servicing.


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