FundsIndia Debt Strategies : Debt Market Ripe for Returns

Instead of calling the tone of the Bi-monthly Monetary Policy Statement hawkish or dovish, we would like to believe that it indicates continuity in the RBI’s view on inflation, as well as growth.

What, however, appears a bit out of syllabus could be the RBI’s confidence in the rupee, that is reflected in allowing higher remittance, as well as allowing additional exposure in the domestic currency derivative market by foreign investors. Besides, the cut in the SLR by 50 basis points appears to suggest that the RBI is signaling banks to stay ready to lend, in the event of a revival in the economy and a consequent increase in credit demand.

Initial cues of end of rate hikes

The no rate change note, although expected, appears to provide initial cues that the rate hike regime may be a thing of the past, unless inflation moves completely out of the trajectory that the RBI has set for it until 2016 (6% by January 2016).

That said, while the RBI’s statement on faster disinflation, providing headroom for a rate cut, seemingly suggests a positive stance, it may not entirely be the case. For one, the RBI has explicitly stated ‘disinflation adjusted for base effects’ – meaning that any lower inflation merely on account of the high base effect (expected between June and November) cannot alone trigger a rate cut.

Two, the rate cuts would also hinge on other policy moves such as fiscal consolidation (will be known during budget) and other factors such as minimum support prices or rural wages, all of which play a key role in the inflation chart. Hence, the impact of policies and reforms of the new government will play a key role in the rate change decision.

Ripe ground

Be that as it may, on the policy side, the debt market has shown some steady traits since September, post Dr. Raghuram Rajan’s takeover as the Governor of RBI. One, the 10-year gilts have been mostly range bound and less volatile, mostly in the 8.5-8.75% levels in recent months.

Two, such stability has lead to a massive increase in positions of FIIs in the debt market 2014. In fact, the RBI’s move to cut SLR, in a way, suggests that the government has sufficient capital flows coming from other-than-bank sources for its bonds.

FII’s net investment in the debt market has close to doubled between January and May of 2014, when compared with similar 5 months of 2013, suggesting a build up of positions on rally expectations.

What it means for retail MF investors

We believe that the bond market may be ripe for a rally over an 18-month plus time frame, if inflation does not stray away from the RBI’s comfort zone. While this may mean taking positions in long-dated funds, we believe that retail investors should be strictly guided by their time frame of investment when it comes to investment in debt funds. This is to avoid burning their fingers as was the case in mid-2013.

For those with a less than 1 year investment time frame, ultra short term and short-term debt funds would provide sufficient returns without taking undue risks or enduring volatility. Click here to check our Debt funds with a 1-2 year horizon in our Select funds’ list.

For investors building a long-term portfolio, or those with a time frame of 2 years and above, income funds that have a mix of corporate and government bonds would provide sufficient opportunity to ride any price rally in bonds when rates fall.

However, such a holding would mean flat returns in the short to medium term and hence, they may not be suitable for those seeking instant gratification. You can click here to refer to our Select funds for long-term debt funds to take advantage of such opportunities.

While we do not expect any rate easing before at least 2 quarters, if you are specifically looking to take a bet on interest rates, while withstanding volatility, and if you have at least a 2-year time frame, then the following funds may help ride an interest rate rally more aggressively.

UTI Dynamic Bond

True to its name, this income fund has dynamically managed its portfolio. From an average portfolio maturity of 2.9 years in March, this fund increased its maturity profile to as much as 8.5 years, loading its portfolio with government securities. Government securities now account for 60% of its portfolio. The rest of the assets are mostly in corporate bonds with AA+ and AA rating.

So why are we recommending this fund for the risk takers? Because the government securities and the longer maturity profile would mean a good rally when rates fall. On the other hand, any rise in rates can actually hurt this portfolio, unless the fund manager dynamically reduces the maturity profile.

It is to reduce the impact of any unexpected hike in rates that we chose a fund with a mix of gilts and medium-term maturity bonds, instead of a pure gilt fund.

Templeton India Income Builder

This income fund is again, an aggressive option. But it has lower exposure to government securities (30%) compared with the UTI fund. It’s portfolio maturity at 4.6 years, is also much lower. That means the fund, while seeking to capture returns from a rate rally, is more active on the corporate bond segment.

The fund has close to 50% of its assets in corporate bonds, including PSU instruments. About 16% are in money market instruments to provide sufficient liquidity. Again, on the corporate bond side, it has a number of instruments with AA rating, but mostly from well-known quality companies.

Between the above 2 funds, we would term UTI Dynamic Bond as the riskier one, given its direct bet on the rate cycle. Templeton India Income Builder too, is not for conservative investors. Both funds require time frames of not less than 2 years.