Rate Trajectory and Portfolio Stability: Tejas Soman of PPFAS on India's Fixed Income Outlook

In an environment marked by global monetary policy shifts and domestic inflation concerns, navigating the fixed income landscape requires a disciplined approach and clear strategic vision. India's debt market, in particular, is poised at a critical juncture, with investors keenly watching the Reserve Bank of India’s next move. To gain insight into the prevailing interest rate trajectory, the crucial role of liquid funds, and the strategies for balanced portfolios, Live Mint spoke with Mr. Tejas Soman, Chief Investment Officer – Debt at PPFAS Mutual Fund. Here are his views on steering through market volatility and capturing opportunities in the debt and hybrid categories.

The Interest Rate Landscape

1. What’s your view on the Indian debt market, and how do you see the interest rate trajectory shaping up in the short to medium term?

Tejas Soman (TS): Our outlook on the Indian debt market is one of cautious anticipation. Domestically, the Reserve Bank of India (RBI) remains committed to anchoring inflation towards its target, and global central banks continue to maintain a relatively restrictive monetary stance.

In the short-term, we anticipate that interest rates will likely remain elevated, hovering near the peak of the current cycle. The RBI’s "withdrawal of accommodation" stance suggests they will err on the side of caution. In the medium-term (looking ahead 12-18 months), we expect conditions for a potential pivot to emerge. If domestic inflation cools consistently and major global central banks begin to ease policies, the focus will shift from holding rates to the timing and pace of rate cuts. For investors, the current high yield environment offers an attractive opportunity to lock in higher rates, especially in medium-to-long duration papers.

2. What impact will geopolitical risks have on interest rates? Do you foresee any risks in the short-term that can impact yields?

TS: Geopolitical risks, sadly, are a constant factor in today’s macro environment, and their primary transmission channel to Indian interest rates is through commodity prices, particularly crude oil. As India is a major importer of crude, any spike in oil prices due to regional conflict or supply chain disruption directly increases domestic inflation, impacts our trade deficit, and requires the RBI to maintain a tighter monetary policy for longer. This directly pushes bond yields higher.

The most significant short-term risks to yields are: unexpected crude oil volatility above certain levels, and persistent hawkishness from the US Federal Reserve, leading to a sudden spike in the US 10-year Treasury yield, which often triggers capital outflows from emerging markets like India and pressures domestic yields upward.

The Role of Liquid and Debt Funds

3. With increasing market volatility, what role can liquid funds play in an investor’s portfolio, particularly for those with a short-term investment horizon?

TS: Liquid funds are the anchor of stability in a volatile portfolio. Their role is threefold: Preservation, Liquidity, and Opportunity. For investors with a short-term horizon (say, 1 day to 6 months), liquid funds are indispensable for capital preservation and providing higher returns than a typical savings account. When equity markets are volatile, an investor can temporarily park their emergency or contingency funds here. Crucially, they act as a staging area for opportunistic investments. By using a Systematic Transfer Plan (STP) from a liquid fund to an equity fund, investors can benefit from volatility by deploying capital gradually or timing market entry, while their capital earns reasonable returns waiting on the sidelines.

4. One of the uses that liquid funds are put to us to park idle cash. What are some of the key advantages of liquid funds that investors tend to overlook?

TS: Beyond simply parking idle cash, investors often overlook the structural advantages that make liquid funds uniquely safe and efficient. One key advantage is their high capital stability, stemming from the rule that securities with a residual maturity of up to 30 days are exempt from daily "Mark to Market" (MTM) fluctuations. This shields the portfolio from the daily interest rate volatility that affects longer-duration funds, ensuring a very smooth NAV trajectory. Additionally, most fund houses now offer an instant redemption facility up to a certain threshold through UPI/Net Banking, providing near-zero-latency access to funds. Finally, there is no exit load for any withdrawal, regardless of the holding period, making them ideal for high frequency cash management.

5. How do liquid funds manage credit risk, and what measures does your fund house take to ensure the safety and liquidity of these investments?

TS: The management of credit risk in liquid funds is governed by strict SEBI regulations, which limit exposure to high-quality instruments. Liquid funds are mandated to invest in money market instruments with a residual maturity of up to 91 days. The short duration itself is the first layer of risk control. At PPFAS, we take a conservative approach, often going beyond the minimum requirements to ensure maximum safety and liquidity. We primarily focus on Government Securities (G-Secs) and highly-rated instruments issued by Public Sector Undertakings (PSUs) and established banks, maintaining a very high focus on A1+ rated paper. Our investment philosophy ensures we prioritize safety and liquidity over chasing marginal extra returns through lower-rated or illiquid instruments.

7. What are the various types of debt funds available and how do investors decide which one is best suited for you?

TS: Debt funds can be broadly categorized by their duration (interest rate risk) and credit quality (credit risk). Based on duration, you have Liquid and Ultra-Short funds for horizons under one year, Short/Medium Duration funds for 1-4 year goals, and Gilt/Dynamic Bond funds for long-term goals when anticipating rate cuts. Based on credit quality, you have Corporate Bond funds and high-quality options like Banking & PSU funds. The best fit depends entirely on your Investment Horizon and your View on Interest Rates. For instance, if your horizon is 2-3 years, a Short Duration or Banking & PSU Fund is prudent. If you have a long-term horizon and believe rates will fall soon, a Gilt Fund is worth considering to maximize capital appreciation.

8. Could you elaborate on the concept of 'mark to market' for debt funds and explain how it impacts an investor's returns, especially during periods of market stress?

TS: Mark to Market (MTM) is simply the daily valuation of a fund's bond portfolio based on current market prices. This is crucial because of the inverse relationship between interest rates (yields) and bond prices: When interest rates rise, the price of existing bonds falls, and vice versa. During periods of market stress, such as a sudden surge in inflation or unexpected central bank tightening, bond yields spike quickly. This instantly causes the market value of the bonds held by the fund to fall, resulting in a temporary drop in the fund's NAV. The MTM impact is most pronounced in long-duration funds. However, it is important to remember that this MTM loss is only a paper loss unless the investor redeems during the stress period; if they remain invested till the bond's maturity, the temporary price volatility smooths out.

Debt vs. Hybrid Funds and Future Outlook

6. For investors looking for a balance between growth and stability, what are the key differences between debt and hybrid funds, and how should they decide which is right for them?

TS: The fundamental difference lies in the growth component and volatility tolerance. Debt Funds are stability-focused, aiming for income generation and capital preservation, relying mostly on interest rate movements and credit quality. Hybrid Funds, however, offer a balance by allocating across both equity and debt, providing equity’s growth potential combined with debt’s stability. Investors should choose Debt Funds if their goal is short-to-medium term (1-4 years) or their absolute priority is capital stability. Conversely, choose Hybrid Funds if your goal is long-term (5+ years) and you need returns that comfortably beat inflation. Funds like Balanced Advantage Funds (BAFs) are particularly useful here as they dynamically manage the equity-debt mix to reduce risk during market extremes.

9. Looking ahead, what are the biggest opportunities and challenges you foresee for investors in the debt and hybrid fund categories?

TS: We see significant opportunities balanced by a few structural challenges. The biggest opportunity is the high starting yields available now, with rates near multi-year highs. Investors who lock in these yields, especially via Target Maturity Funds or long-term bond funds, stand to benefit significantly from capital appreciation once the rate cut cycle begins. Furthermore, Dynamic Hybrids (BAFs) offer an excellent risk-adjusted return profile by automatically de-risking when equities are expensive. The key challenges, however, include the uncertainty over the RBI's pivot timing and the structural change in taxation, where the removal of the indexation benefit for non-equity funds has made long-term debt holding less tax-efficient for those in higher income brackets.

As Mr. Soman emphasises, while the near-term presents volatility stemming from geopolitical risks and interest rate uncertainty, the current high yields offer a historic opportunity for patient fixed-income investors. The key to successful debt investing remains a focus on superior credit quality, aligning duration with one's investment horizon, and utilizing liquid and hybrid funds strategically. By maintaining discipline and avoiding the temptation to chase marginal returns, investors can effectively stabilize their portfolio and prepare for the capital appreciation potential that the future rate cycle may bring.