Debt market: Economy on mend, growth will be sustainable, non- inflationary

Amit Tripathi

Amit Tripathi

CIO, Fixed Income Investments
Reliance Mutual Fund

The debt market story in India keeps on getting better. The genesis of the same lies in the fiscal discipline that the central government has adopted in the last 2- 3 years. The improvement is even more meaningful because it’s both quantitative as well as qualitative. This marked improvement in the fiscal discipline, accompanied by adequate supply side responses has ensured that the trend Consumer Price Inflation (CPI) has almost halved from 10% levels down to 5% levels in the last 3 years.

Clearly both the RBI as well as the government has been on the same page in terms of prioritizing macro stability over short term impulses to boost growth. This ensures that as the economy rebounds, the growth will be much more sustainable and non-inflationary.

This drastic improvement in the India macro parameters has been achieved during a time when the world economy is going through a lot of turmoil and uncertainty. The last three years have seen it all. Fed rate hikes, huge volatility in commodity prices, huge G-10 currency volatility and now Brexit. In all this India has stood out tall. The rupee’s resilience in such trying times is for all of us to see.

This level of macro improvement and fiscal discipline has created the comfort and the space for the RBI to cut rates by more than 150 bps since January 2015. The April 2016 monetary policy decision of moving the banking system liquidity from deficit to neutral / positive territory is a game changer as far as transmission of rate cuts is concerned. This will arguably be a much bigger driver for real life interest rates to come down.

We expect interest rates to come down further over the next 12 to 24 months. The rate cuts accompanied by better liquidity conditions will ensure that all segments across the debt markets will do well. We expect a further bull steepening of the yield curve. Essentially the quantum of decline in rates may be higher at the short end (1 to 5 years), but the absolute amount of capital gains at the longer end of the yield curve will compensate.

Separately, carry will be a big driver for investment allocation decisions as overall rates come down. The gradual rebound in growth, decline in interest costs and government policy led intervention will improve corporate balance sheets both from a leverage and cash flow perspective. This will create attractive investment opportunities for investors in the private sector corporate space.

To capture these attractive investment opportunities through mutual funds, investors should look to allocate between corporate bond funds (mixed grade portfolios, alpha creation through exposures to well research private sector companies) and dynamic bond funds (high grade portfolios, alpha creation through active duration management). The allocation within these two options should be decided basis the time horizon of investments and the comfort that investors have in terms of credit risk and duration (interest rate volatility) risk. Investors may also choose to allocate to long term closed end funds (Fixed Maturity Plans), which helps them capture the current attractive yields in the PSU as well as private sector corporate bond space. Investors staying over 3 years will also get attractive indexation benefits which enhances the returns on a post tax basis.

For investors with a short term horizon, the allocation should be predominantly in ultra short term bond funds and short term bond funds, which offer reasonable carry as well as potential capital gains as rates come down and the yield curve steepens.

Given the overall market environment, as well as unique positioning of various debt schemes of mutual funds, investors will get superior savings / investment solutions vis a vis other traditional avenues such as deposits etc.