Reserve Bank of India (RBI) Governor Raghuram Rajan has a knack for surprising the markets. In his first monetary policy review in September 2013, when the market expected him to cut the repo rate, at which banks borrow from the RBI, he did exactly the opposite. He increased the rate by 25 basis points, or bps, to 7.50%. Thereafter, the repo rate has been increased by another 50 bps; at present, it is 8%.
This is understandable, for Rajan's most important task at this stage is fighting inflation. In the first and second bi-monthly policy review (April 1 and June 3), Rajan kept the rates unchanged in view of the fact that the consumer price inflation, or CPI, (ex food & energy) has moderated but is still at elevated levels. However, he reduced the statutory liquidity ratio, or SLR, by 50 bps to 22.5% of banks' net demand and time liabilities.
"As the economy recovers, the demand for credit will rise. To meet this demand, the RBI has reduced the SLR requirement for the banking system," says Rahul Goswami, CIO, fixed income, ICICI Prudential AMC.
With interest rates rising, the yield on the 10-year benchmark government bonds has gone up from an average of 8.3% in 2012 to 8.80% to 9%. When rates rise, the demand for older bonds (on which the coupon or interest rate is lower) falls, leading to a fall in their prices and, thus, a rise in yields.
"While short-term yields are benchmarked to the overnight rate, the overnight rate has been 8% for the last two years," says R Sivakumar, head of fixed income and products, Axis AMC. This is reflected in the performance of ultra short-term debt funds and short-term debt funds, which have returned 9.2% and 7.5%, respectively, in the last one year since 28 April 2013.
Long-term debt funds (income funds) and long- and medium-term gilt funds have returned 3.6% and 0.2%, respectively, during the period. "Clearly, the short-term sector has not been affected by rate increases, unlike long-term and gilt funds," says Sivakumar. When interest rates rise, bond prices fall, and vice versa.WHERE ARE RATES HEADED?
According to Sivakumar, if inflation undershoots this projection, we should see softening of rates over the next 12 months. "The two factors keeping inflation high have been food inflation and currency depreciation. Food inflation has started falling. The rising rupee, too, is expected to lead to moderation in core inflation," he says.
A lower inflation may encourage the RBI to cut interest rates, pushing up prices of existing bonds (which have a higher coupon rate) held by debt funds. This will increase returns from these funds. After having said that, there are a few factors that may increase inflation and thus trigger an increase in interest rates. According to Santosh Kamath, CIO, fixed income, Franklin Templeton Investments, India, "Although the wholesale price index (WPI) inflation has edged towards the RBI's comfort zone of 5-5.5%, headline and core CPI inflation are still at elevated levels."
"We also need to keep in mind that fuel prices in India are still not fully aligned to global price movements. Plus, there is seasonality in vegetable prices. These could keep inflation and policy rates at elevated levels for an extended period," he says. Then there are concerns regarding El Nino, which may impact the monsoon, and in turn food inflation. But the risk to RBI's inflation target is likely to be balanced by the government's efforts towards fiscal consolidation and better food supply management.In a nutshell, the uncertainty around interest rates is likely to continue in the foreseeable future. "Hence, it is important that investors take the asset allocation approach based on medium-term objectives rather than trying to time the market in the next six months," he says. In the current scenario, those with a short horizon of up to six months can invest in liquid funds and low duration funds, while those with a horizon of 12-18 months can look at short-term debt funds and dynamic bond funds. Further, there has been a substantial softening of yields on fixed maturity plans as one-year commercial paper rates have fallen from 9.60% to 9.15%.
Sivakumar says this is not unusual when we move from the fourth quarter, when liquidity is tight, to the first quarter. As the government resumes spending, yields on short-dated assets can drop as liquidity eases, which will benefit funds investing in those assets. Hence, short-term funds may become attractive. "Corporate bond funds that can benefit from the high yields being offered will remain a compelling investment over the medium term," says Kamath. Investors with a longer horizon of one-two years can look at long-bond funds that offer high yields plus capital appreciation.
Goswami of ICICI Prudential also says that fiscal consolidation, continued improvement in the current account and moderating CPI could provide the RBI space for monetary easing and lower interest rates. "We continue to remain positive on interest rates and in next four-six quarters there could be about 100 bps decline in bond yields. In light of this, we believe that the current 10-year bond yields of 8.75% are attractive and continue to advocate medium-term and long-term duration funds," he says.
"However, investors need to be aware that while such funds can deliver over the medium to long term, they could witness significant volatility in the short term," says Kamath.
Investors can also consider funds that invest in debt and money market instruments issued by banks and public sector undertakings or PSUs. In the current environment, banks and PSUs dominate the corporate bond market in terms of outstanding and primary issuances as well as volumes. Debt and money market securities issued by banks and PSUs are perceived to be less risky than other fixed income instruments due to regulatory structures and ownership. These funds, he says, are suited for those who want to invest in fixed income products with a horizon of one-two years.