Market Strategy: How to structure Fixed Income portfolio in a changing interest rate environment?

Indian government bond yields traded higher on Monday, with the benchmark 10-year yield hovering around 6.7367%, driven by an uptick in U.S. Treasury yields. Investors’ attention has now shifted to the Federal Reserve’s upcoming monetary policy decision later this week.

The domestic yield curve has exhibited a downward shift since October 2023, supported by favorable demand-supply dynamics, contained inflation levels, and stable macroeconomic indicators. However, a combination of global and domestic factors over the past two months has introduced interim volatility, leading to an upward movement in yields.

Over the last year, yields on long-term Government Securities (G-Secs) have eased by 40–50 basis points (bps), despite intermittent fluctuations. According to Motilal Oswal Private Wealth, long-term yields are expected to remain volatile, influenced by adverse growth and inflation data, global macroeconomic trends, and ongoing geopolitical tensions.

On the global front, the US Federal Reserve has reduced interest rates by 75 bps since September, and market expectations for an additional 25 bps rate cut this week have risen to over 97%, as per the CME FedWatch Tool. However, the probability of a rate cut in January stands at a modest 17%.

Domestically, the Reserve Bank of India (RBI) has maintained the repo rate while reducing the Cash Reserve Ratio (CRR) in its December monetary policy, signaling the potential for a rate cut in February 2024.

In light of these evolving interest rate dynamics, here’s how investors can structure their fixed-income portfolios effectively:

Fixed Income Portfolio Strategy

Motilal Oswal Private Wealth recommends maintaining an Overweight position on Accrual Strategies while staying Neutral on Duration Strategies in the current fixed income market environment.

Duration Strategies

Regarding duration, Motilal Oswal notes that a significant portion of the yield easing in the 10-year G-Sec has already occurred, with yields declining from 7.35% in October 2023 to approximately 6.75% in December 2024. The remaining potential for further easing is limited and may be accompanied by interim volatility. Investors can capitalize on this final phase through longer-maturity G-Sec bonds or funds.

It recommends allocating 15%–20% of the portfolio to Actively Managed Duration Funds or Long-Term G-Sec papers/ funds (15–30 years average maturity).

Accrual Strategies

Accrual strategies can be leveraged across the credit spectrum, with allocations tailored to deliver stable returns. Motilal Oswal suggests the following breakdown:

– 40%–50% of the portfolio should focus on Performing Credit & Private Credit Strategies, including InvITs and select Non-Convertible Debentures (NCDs).

25%–35% may be allocated to Performing Credit Strategies, InvITs, and NCDs.

>15%–20% may be invested in Private Credit, including Real Estate/ Infrastructure strategies and select NCDs.

– 15%–20% of the portfolio may be allocated to shorter-term instruments such as:

> Arbitrage Funds (minimum 3-month holding period),

> Floating Rate Funds (9–12 months holding period), and

> Absolute Return Long/Short Strategies (minimum 12–15 months holding period).

– Tax-Efficient Fixed Income Alternatives

To optimize tax efficiency, the report recommends allocating 20%–25% of the portfolio to Conservative Equity Savings Funds with a minimum holding period of 3 years.

This portfolio strategy aligns with the evolving interest rate environment and seeks to balance return potential with risk mitigation.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.