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Debt mutual fund investments in 2022


One can expect normalcy to return to the monetary policy framework across the world. People have learned to live with the virus and the policymakers will look to roll back the extraordinary stimulus delivered during the last two years.

In fact, the process of rolling back the stimulus has already started with many central banks across the emerging markets and domestic markets, hiking rates this year.

We believe that this trend will continue next year as well. In our view, more than the normalization of policy rates, the management of the humungous liquidity surplus across world financial markets will be the key challenge facing the central banks.

This will also lead to some surprises and volatility in the markets. The US Fed has already started the tapering of its bond-buying operations and the March 2022 meeting of the US Fed will be a live meeting as far as the start of the US rate hiking cycle is concerned.

From the perspective of domestic markets, the Reserve Bank of India (RBI) has initiated actions to normalise the monetary policy by increasing the amount of liquidity absorbed under Variable Rate Reverse Repo (VRRR) and we expect the repo rate to become the operational rate from February or March 2022 onwards, with the rate hiking cycle starting from April 2022.

Domestically also, we believe that the management of liquidity surplus will be the key for RBI as durable liquidity exceeds Rs 11 lakh crore.

What do rising rates/yields and tighter financial conditions mean for investors of debt mutual funds for 2022 and beyond?

The current market yields are already factoring in the rise in rates which is reflected in the steepness of the yield curve and as such yields may not rise sharply in response to rate increases by central banks as long as it is on expected lines.

We think two main themes will play out next year:

(1) Along with hiking rates, RBI will also stop infusing liquidity into the markets and as the liquidity surplus reduces with higher credit growth, we believe that corporate spreads will start to rise from the current historically low levels. The current corporate spreads are not pricing in normalisation of liquidity.

(2) Incrementally the curve will flatten with short term rates rising more than long term rates.

In this backdrop of rising rates, both domestically and globally, we would recommend that investors invest in actively-managed short term income strategies. Actively managed short term funds will be in the best position to not only navigate this inflection point in the interest rate cycle but can take advantage of the expected spread widening between the sovereign curve and the corporate curve.

Investors can also look at some specific strategies like the Roll Down Strategy given the steepness in the curve and a Ladder Portfolio Strategy. A ladder structure typically invests equal proportion across the curve with a target maturity in mind. In a ladder structure, assuming a target maturity of five years, the investment will be spread into equal proportions in one-year/two-year/three-year/four-year/five-year segments, which means 20% every year.

The advantage of such a structure in a rising rate environment is that a part of the corpus which gets matured every year will get reinvested at a higher yield at the targeted maturity point of the structure.

Thus in a ladder structure after one year, the bond maturing in 2022 will get reinvested in a 2026 maturity bond (which will presumably happen at a higher yield given the expectations of rise in rates and spread widening). Thus, the yield of the portfolio will continue to increase till maturity.

To summarise, we expect the management of liquidity to be the key challenge for central banks in 2022, which can lead to surprises and investors should prepare for some volatility. Debt mutual fund investors are advised to increase allocation to actively managed short duration funds and in some specific strategies like the Ladder Strategy, explained above.

(The author is Head – Fixed Income, PGIM India MF. Views are his own.)



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