How to rebalance your mutual fund portfolio in a changing interest rate environment

Rising interest rates make it imperative that fixed income investments or portfolio be scrutinized for necessary changes and realignments. But don’t get the impression that only fixed-income investments are sensitive to interest rate fluctuations. In fact, all asset classes, including even equity investments, are equally affected by rate changes.

As interest rates rise, the value of fixed income portfolios gradually declines, and the biggest drop is at the long end of the curve, or in long-term or long-dated instruments. The longer the duration of the portfolio, the greater the loss in value and therefore the obvious action to take is to reduce the duration of the portfolio. In other words, stay at the short end of the curve or invest in short-dated instruments to minimize loss in value. This is one of the main actions to take on portfolios against rising interest rates. However, at some point, even portfolios or short-term instruments can be negatively affected, although to a lesser extent. This too can be overcome by moving to very short term like overnight funds or liquid funds, or one month treasury bills etc. This shift invariably anchors the portfolio to relatively lower yields for some time.

One way to keep the portfolio more stable is to switch to floating rate instruments. These instruments have a floor and a cap in the coupon, and the coupon resets at periodic intervals based on movements in the benchmark index. When the performance of the benchmark index increases or decreases, the coupon of the instrument you hold will also reset. Any rise or fall in yields would be reflected in the coupon. There are several instruments in the mutual fund space that help preserve portfolio value along with other benefits of long-term investing. In case the investment time horizon is three years or more, debt products that offer higher yields such as SDL funds or fixed maturity plans with a portfolio yield of 7% and above could be invested. At the end of the period, that is to say after three years, we can also benefit from indexation, which allows an almost tax-free return higher than the tax exemptions of around 150 basis points.

To achieve optimal results from the investment portfolio, it is important not only to reduce duration as interest rates rise, but it is also important to return to the long end of the curve as soon as interest rates rise. are stabilizing, and it’s time to capture the higher portfolio returns. Capturing peak yields is not always possible. What is more feasible is to move in as soon as the level reaches reasonably high levels based on historical averages on the baseline. Studies have shown that once an investment is made at levels above the historical median, the likelihood or likelihood of the investment earning a high single-digit return is very high. However, it is also important that a favorable macroeconomic environment is a prerequisite for the performance of bond portfolios.

Another thing to consider is credit risk. Investors are likely to be swayed by the high yields offered on low credit papers, which may seem very tempting. But very often credit risk factors are triggered in rate hike scenarios for two reasons. The first cost of borrowing increases and hence the cost of funds and liquidity can also be a victim in such situations. Second, rising rates can hurt borrowers’ debt-servicing capacity. This calls for better due diligence on the credit risk front.

The key to checking the health of portfolios is to do comprehensive reviews on a monthly or quarterly basis. These reviews should be performed by experienced securities or investment advisers. The more frequently and efficiently these reviews are carried out, the better it is to optimize portfolio efficiency.

(Joseph Thomas is Head of Research at Emkay Wealth Management)

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