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Whenever the fiscal situation of the government worsens, bond yields inch up as investors seek a premium for taking exposure to riskier securities. And perhaps for the same reason, in the last one year, the spreads on yields of State Development Loans (SDL) over that of 10-year G-secs rose from 28 basis points to 60 bps. In fact, in February, ahead of the Union Budget, spreads were higher at 85 bps.
As per Nomura estimates, with the busy season kicking in, the spreads are expected to remain high, going forward. Nomura expects the yield curve to get steeper; interest rates would be lower at the short end, higher at the medium to long end.
Is there a way for investors to profit from higher yields, provided they are willing to take the risk? While retail investors wouldn’t be able to take exposure in SDLs directly, they could invest via mutual funds, especially gilt funds. SDLs issued by Maharashtra, Karnataka, Punjab and Jammu and Kashmir are already in the portfolio holdings of some gilt funds. While Kotak Gilt Invest Fund has an exposure of 25 per cent into SDLs, it was 5.4 per cent for ICICI Pru Long term Gilt. Long-term gilt funds of SBI, HDFC and IDFC had negligible (less than one per cent) or zero exposure to SDLs.
Some gilt debt funds, which invest in SDLs, are also looking at opportunities to invest in UDAY bonds. “We are keenly tracking UDAY bonds; with better clarity on its ownership structure,” says Abhishek Bisen, fund manager at Kotak Mutual Fund. Many bond traders feel that liquidity premium (the premium paid for lower liquidity) for such bonds is not appropriately priced by the market. So, they were seen trading in it to profit from inefficient pricing.
However, interest rates at the longer end will remain under pressure and could also rise, if the combined borrowings of the State and Centre shoot up. If this happens, it could impact returns of investors in long-term gilt funds, especially those running longer duration on their portfolio.
Longer duration bonds are more sensitive to changes in interest rates. So, investors should be cautious. Many gilt funds have already reduced duration of their portfolio in the last few months, despite the RBI’s accommodative stance.
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