He highlights how direct bonds offer long-term capital gains benefits but limited scope for capital appreciation, while debt mutual funds provide the advantage of deferred taxation.
Yadav also points to income-plus-arbitrage and certain hybrid funds as potentially more tax-efficient options for long-term investors.
With government bond yields now at attractive levels, treasury heads are actively thinking about making purchases. After the RBI’s FCNR(B) scheme ended, the five-year bond yield closed at 6.52%. Although there’s speculation about a delay in renewed buying due to upcoming policy minutes, the banking sector’s liquidity remains robust, with funds ready to be invested shortly.
In an interaction with Kshitij Anand of ETMarkets, he also shares his outlook on interest rates, the case for locking in yields now, and how investors could deploy ₹1 crore in fixed income over a three-year horizon. Edited Excerpts –
Q) What is your take on the MPC policy meeting outcome? Do you see interest rates going higher or lower in the near term?
A) The RBI’s decision was along expected lines. Given the uncertainties surrounding the Iran conflict and monsoon patterns, the RBI had little choice but to wait and watch the data.
Looking ahead, we expect their next move to be a rate hike. With global inflation rising, strong economic data from both the US and India, and the US Fed leaning towards hiking rates, the RBI’s next move looks like a hike.Q) With the RBI repo rate at 5.25%, are we still in an environment where investors can lock in attractive yields, or has the best part of the rate cycle already passed?
A) Funds investing in money market instruments and short-term bonds still offer great value. The extra carry they offer over the repo rate remains attractive. Since a rate hike is still some time away, high starting yields act as a strong cushion against any yield rise.
Q) Is it better to lock in a 7% yield on a high-quality bond today or wait for potentially higher yields if inflation or oil prices push rates up?
A) Waiting for a better yield comes with a carry loss. If you were to park your money in an overnight fund, your daily returns would be nearly 2% lower. The opportunity cost of sitting on the sidelines for any rise in yields is very high. It makes much more sense for an investor to lock in those yields today.
Q) If you had ₹1 crore to deploy in fixed income today with a three-year horizon, how would you construct the portfolio?
A) I would focus on higher-yielding, good credit bonds, because that higher yield provides a buffer against market volatility. Specifically, short-maturity NBFC bonds, which can offer yields above 7.5%, are an excellent choice right now. Shorter maturity ensures that the portfolio takes less of a hit if yields spike.
Q) How should investors divide their fixed-income allocation between government bonds, AAA corporate bonds, credit opportunities and money-market instruments?
A) We prefer corporate bonds and money market instruments because their higher yields offer a natural cushion against volatility. Government securities, on the other hand, yield much less and can actually be more volatile since they react heavily to uncertain news and economic data. While we don’t see major issues with credit opportunities, AAA-rated NBFC papers are currently offering good yields with a favorable risk-reward ratio.
Q) Do you think that a bond fund makes more sense than buying individual bonds, and when does direct bond ownership have an advantage?
A) A bond fund is generally the better choice, especially if an investor lacks dedicated expertise and resources to analyze credit risk. Direct bonds lack diversification and can turn illiquid when you might need to exit during stressful market conditions.
However, direct bonds do make sense in two scenarios: first, if a mutual fund’s diversification ends up diluting yields for the same level of risk; and second, if you can buy a long-term bond at a huge discount to take advantage of better Long Term Capital Gains benefits.
Q) How important is tax efficiency when comparing FDs, bonds, debt mutual funds and government securities?
A) Tax efficiency is a critical factor. While direct bonds offer Long Term Capital Gains benefits, they rarely generate capital gains of more than 5% over the holding period, making this benefit minimal.
Plus, the regular coupon income from bonds is taxed every time it is paid out. In contrast, with debt mutual funds, you pay tax only when you redeem, giving you the benefit of deferred taxation.
However, if you invest in an Income + Arbitrage Fund of Funds, or a specific hybrid fund, the tax benefits become very significant. Income + Arbitrage funds attract a 12.5% tax rate after a two-year holding period, and hybrid funds benefit from equity taxation rules.
For investors who can hold for the long term, this tax difference makes these funds highly lucrative.
Q) What is the biggest misconception about bonds in India today—that they are boring, low-return investments?
A) India has a young demographic, and the economy is growing at a robust pace. Because ambitions and expectations are so high, it’s hardly surprising that many investors view fixed-rate bonds as boring and low-return. The massive inflows into equity funds, at the expense of debt funds, perfectly mirror these public expectations.
What bonds truly provide is capital preservation. While we certainly don’t want the Indian growth story to weaken, the reality is that the public’s perception of bonds will likely only change when they experience muted returns in the stock market.
Developed markets with slower growth naturally appreciate bonds more, and it may just take some time for the general public in India to develop that same level of interest.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)