As India is now targeting CPI infl ation instead of WPI, valuation of the bond curve looks all the more attractive
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"Valuation of the bond curve looks attractive"

The demand for Indian debt from should continue to be strong, which will support the bond valuations

Puneet Pal   
Puneet Pal, head, fixed income, BNP Paribas Mutual Fund

As India is now targeting CPI inflation instead of WPI, valuation of the bond curve looks all the more attractive

As we step into the New Year, debt fund investors may look back at the year gone by with mixed feelings. The year started with big expectations and the RBI obliged with 125 bps rate cuts, which was more than market expectations.

The yield curve steepened as a result of these rate cuts with the shorter end outperforming the longer end of the curve. The 10-year benchmark yield largely remained unchanged, primarily due to the fear of an adverse impact on the INR if the US Fed had raised policy rates.

Understandably, there is some anxiety in the minds of debt investors about what to expect from their investments next year. The US Federal Reserve's actions, the stability of the Chinese economy and that of commodity prices, along with India's inflation trajectory will be key to the performance of the debt markets.

Given that the rest of the world is still struggling for growth and the US dollar strength has the potential to weaken the US growth, the US Fed may hike rates very slowly - the first hike in December 2015 will be followed by two rate hikes in 2016.

Commodity prices are expected to remain low as the biggest consumer, China, is slowing down rapidly. Oil prices are also expected to stay low due to huge stockpiles in US, and the expected increase in supply from Iran. IEA data on global inventory levels of crude oil estimate say there is an excess supply of around 300,000 barrels per day with shale oil supply still steady at close to 9 50,000 barrels, even after a fall in the rig count to half from the start of the year. We expect the supply glut to continue over the next year.

The government is likely to meet the fiscal deficit target of 3.90 per cent of GDP for 2016/17. However, with the impending 7th Pay Commission recommendations resulting in additional outgo to the tune of 0.40 per cent of the GDP for 2016/2017, the government has to fast track the structural reforms with a bit of support from lower global commodities and better rains to be on the tight fiscal consolidation path.

Currently, the bond markets are factoring in a lot of negative news and from a valuation perspective long bonds are looking quite good. The spread over the benchmark repo rate is 100 bps as against the median spread of 50 bps. From an international perspective, as against the median spread of 455 bps between the US 10-year benchmark and the Indian 10-year, the current spread is at 555 bps. As India is now targeting CPI inflation as opposed to the earlier WPI, and also intending to keep the real rates positive, valuation of the bond curve looks all the more attractive.

The INR has also outperformed majority of the emerging market currencies and has, in fact, strengthened against the Euro and the Yen. This is the result of India following a prudent fiscal and monetary policy. Even after the electoral setbacks in Bihar and Delhi, the NDA government has continued with the reforms process. We believe that the government along with the RBI will continue to follow a prudent fiscal and monetary policy which will strengthen India's macroeconomic fundamentals.

With this backdrop, we believe that the RBI will have room to cut rates by another 25 bps next year. We also expect that bond yields to head lower by 40-50 bps, given the current valuations. The demand for Indian debt from FPIs should continue to be strong, which will support the bond valuations.

Therefore, investors should allocate their debt portfolios between dynamically-managed bond funds and accrual funds.

Puneet Pal is head, fixed income, BNP Paribas Mutual Fund