With the RBI's first cut signalling a turn in the rate cycle, add funds that follow a duration strategy to benefit from the fall.

Monetary policy review disappointed the debt market because the RBI left the interest rates unchanged. The bench mark 10-year bond yield, which had declined in hopes of a rate cut, shot up from 7.65% to 7.73%. But experts are confident that the RBI will cut interest rates in the coming months. It is widely believed that the repo rate could be lowered by 75-100 basis points in 2015. With inflationary expectations at a 21 quarter low and a benign global environment, we are in the early phases of a prolonged rate easing cycle.

Where should you invest If interest rates are cut, debt funds that have lined their portfolio with long-term bonds will do very well. Long-term gilt funds have given spectacular returns in the past few months. The category has delivered more nearly 18% in the past one year. In the past six months alone the category has given nearly 12%.

However, investors should be careful when to exit because the good times won't last forever. The long-term gilt funds are looking attractive currently when interest rates are falling. But 18-24 months from now when the interest rates stop falling, the returns from these funds could turn sub-optimal. Long-term gilt funds are one-way funds. They invest in long-term government bonds and do not reduce maturity even when the rates have started rising.

Besides long-term gilt funds, there are income funds that invest in a mix of gilts and corporate bonds. Income funds have also done well in the past few months, delivering 14% in the past one year and 8.3% in the past six months (see table). Though the returns may not match those from long-term gilt funds, these funds are more stable. Experts feel this is the category to bet on now.

Choosing the Category

Within income funds, there are schemes that invest in long-term bonds. These duration funds do not lower the average maturity of their holdings below a certain level. While this can be rewarding when interest rates fall, it can lead to losses if rates rise.

Investors who don't want to time the interest rate cycle could consider income funds that focus on the accrual of interest on the bonds in their portfolio.

Another sub-category within income funds is that of dynamic bond funds. These funds are flexible about where they invest. They will try to benefit from a duration strategy when rates are falling, and quickly switch to an accrual strategy when rates are moving up. Sometimes they even go into cash. These are all-weather funds and their fund managers enjoy the maximum flexibility. They are best suited for retail investors' long-term portfolios. These funds underperform only if the fund manager gets his calls wrong.

What are the risks

When you add duration-based funds to your debt portfolio, you run the risk that interest rates may remain stagnant or even move up suddenly. This had happened most recently in the summer of 2013, when a sudden withdrawal by FIIs put pressure on the rupee, forcing the RBI to intervene. In one month, long-term gilt funds fell almost 5-6%.

Similar risks prevail even today. Inflation has softened due to a steep fall in oil prices. If oil prices rebound sharply, inflationary pressures could revive, forcing the central bank to tighten. Second, FIIs have invested a lot of money in India's debt market in the recent past. Any event, such as the Fed rate hike expected in mid-2015, which triggers an exodus of FII money, could lead to tightening.

Remember that higher the average maturity of a duration fund, higher the potential for gains. But such a fund's risks are also commensurately higher.

Your fixed income portfolio

Your long-term fixed-income portfolio should consist of three baskets: funds that hold-to-maturity, accrual funds and duration funds. The hold-to-maturity basket should include bank fixed deposits, fixed maturity plans, NCDs and tax-free bonds. Highly conservative investors, who believe that their fixed-income portfolio should not be volatile, should stick to the hold-to-maturity basket.

Investors who are ready to tolerate some volatility in the quest for higher returns could go for the accrual and duration baskets. Moderate investors may allocate 25% of their fixed-income portfolio to these baskets and aggressive investors up to 50%. When investing in duration funds, have an investment horizon of at least three years to overcome setbacks, such as interest rates stagnating or even moving up temporarily.