How to position your bond portfolio for higher interest rates

Bond yields continue to rise in 2022 with the benchmark 10-year Indian government bond (IGB) yield up around 100 basis points and short-term yields up around 150-200 basis points basis so far this year, as central banks continue to guide rate hike expectations higher to deal with record levels of inflation.

The macroeconomic environment is a key factor in determining its bond strategy going forward with the growth/inflation framework as the central starting point. We expect India’s economic growth to remain above its long-term trend in fiscal year 2023, supported by a weak base, rising fiscal spending and broad-based economic recovery amid recovering economic growth. consumption and private investment.

However, CPI inflation is expected to remain closer to the RBI’s 6% target for FY2023, given the pass-through of high commodity prices, ongoing supply issues and the repressed request. Overall, the above macroeconomic backdrop should lead to a faster normalization of RBI and US Fed policy, pushing interest rates and bond yields higher, the IGB bond yield at 10 years expected to trade above 7.50% over the next 6-12 months.

As an asset class, the positive drivers of bonds are outweighed by the risks. Attractive yield premiums (i.e. the spread between the 10-year IGB and the repo rate), which are near peak levels indicating oversold conditions, are a key positive driver for bonds. Moreover, the real yields of Indian bonds are higher than those of their emerging market (EM) counterparts. However, three factors remain headwinds for bonds: 1) weak medium-term fiscal momentum, 2) a deterioration in the balance of government bond supply given the high supply of government bonds State amid declining RBI support and subdued demand from institutional investors and 3) rising inflationary pressures and faster normalization of policy rates by the RBI and the US Fed.

In our view, a diversified bond allocation can help investors weather a rising interest rate environment by gaining exposure to:

Short-dated bonds: We like short-dated bonds (1-4 years) because they are less price sensitive to rising bond yields than medium- and long-dated bonds. Additionally, the sharp rise in short-term yields over the past year reflects market expectations of a rising interest rate path with the overnight indexed swap spread (OIS) at 1 year, indicating that the RBI should raise policy rates by at least 150 basis points. over the next 12 months. Thus, aggressive pricing of rate increases provides investors with the opportunity to reinvest at higher levels.

Corporate Bonds: Corporate bonds are more sensitive to changes in growth expectations and are doing well in the current environment of above-trend growth. In addition, they are shorter in duration and less sensitive to interest rates. In our view, fundamentals remain constructive for corporate bonds given (i) a likely recovery in the credit cycle amid above-trend economic growth in 2022 and improving asset quality for corporates financial; (ii) a broad-based economic recovery and improved corporate profitability leading to a likely reduction in credit default risk; and (iii) corporate bond valuations appear inexpensive relative to government bonds. Within corporate bonds, a high yield tilt can help improve yields, given the cheap valuations of AA/A corporate bonds relative to AAA corporate bonds in a weaker corporate environment. improvement.

Selective bond strategies such as (1) medium duration target maturity strategies are likely to benefit from higher carry, lower interest rate risk and declining residual maturity, (2 ) Floating Rate Strategies which can help investors offset inflation and duration risk and (3) Dynamic Bond Strategies which provide investors with better accruals and help actively manage duration risk.

Hybrid Strategies: A balanced portfolio with a mix of stocks and bonds can help bond investors looking for yield move up the risk curve by taking some exposure to stocks but with lower volatility relative to a to pure actions.

Overall, the macro backdrop for bond investors is likely to remain challenging as bond yields tend to rise. Thus, it is important for bond investors not only to adjust their future return expectations downward given moderate capital appreciation, but also to have a more diversified bond allocation to offset rising interest rates. interest.

(By Saurabh Jain, Managing Director and Head, Wealth Management, Standard Chartered Bank, India, and Vinay Joseph, Director and Head, Investment Products and Strategy, Standard Chartered Wealth, India)

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