Home / Money / Personal Finance /  There’s now a higher return potential for debt investors

The Reserve Bank of India (RBI) has hiked the repo rate by 35 basis points (bps) from 5.9% to 6.25%. A slower pace of rate hike from last time reflects some incremental comfort that the RBI is drawing on inflation. But it doesn’t signal absolute comfort or any reversal of the rate hike cycle. The RBI has clearly stated two distinct objectives on headline inflation, first to bring it below the 6% threshold, and then further towards 4%. It makes logical sense too.

The trigger for the RBI to get into a series of frontloaded rate hikes (225 bps between May and now) was inflation crossing and staying stubbornly above 6%. The ultimate aim is to move towards 4%, and till the time the RBI is not convinced, we are in for a long pause in interest rates possibly post one more 25 bps rate hike. The other factors in support of this long-pause argument are the continued strength in the domestic consumption economy, and the expected stickiness in core inflation next year. Unless either or both of these factors turn decisively, the RBI may prefer to stay put.

While the monetary policy is predominantly driven by domestic considerations, several external factors too are very relevant. Given the uncertainty, it would be too early for the RBI to lower its guard now. With this backdrop, we mostly have good news, and some not- so-good news on the debt market front. The good news is that markets have already priced in a terminal repo rate of 6.50%. That essentially means that this 35 bps rate hike in itself doesn’t force any change in market pricing. The post policy move in bond prices was muted overall. Maybe the oil price softening is adding to some additional comfort. The not-so-good news is that markets are almost priced to perfection. That’s the reason why the market is not celebrating the drop in the pace of rate hikes.

From an investor standpoint, the most important thing to focus on in the next 12 to 18 months will be the carry (or current yield) across debt portfolios. With successive rate hikes and continued tightening of liquidity conditions, yields across the board have risen significantly in the last 12 to 15 months, especially post March. That means the starting position for an investor entering the debt market in any segment is significantly higher carry (portfolio yield) and hence significantly higher potential returns vis-à-vis what was the case just 6 months back. That should give investors reasonable comfort. Over the medium to long term, a bulk of the return across debt products comes from the portfolio yield, and hence this is the best possible news coming out of the debt markets. The second piece of good news is that most rate hikes are behind us, may be an incremental 25 bps still to go and the markets have already priced that in. That means, the potential for adverse mark-to-market losses is lesser going forward, especially if the investor’s time horizon and his choice of debt products is in line.

The last point to remember is that there is near consensus on the possibility of a significant slowdown in global growth and inflation. If that materializes, the market will start thinking about a reversal in the interest rate cycle, and the market typically tries to price in future RBI actions fairly in advance. This means, for investors who have a 2-3 year plus kind of a time horizon, not only do they have to focus on the near term but also on the medium term from a return preservation perspective. In our mind, the best way to achieve this would be to allocate a large part of your near-term debt allocation into intermediate duration debt funds (funds which invest typically in 2 to 5 years assets). Short term Bond Funds, Banking & PSU Debt Funds, corporate bond funds, fit the bill well. The other alternative would be to look at a range of intermediate duration target maturity funds.

Lastly, allocation to long duration products, while not offering very rich initial prospects given a flat yield curve (30-year G-Sec yields are just 25 bps higher than 5-year G-Sec yields), should not be overlooked specially for 4-5-year or longer investment horizon. That’s because while over the next 9-12 months any type of monetary easing is remote, that story could change if the time horizons are longer.

Amit Tripathi is CIO–fixed income investments, Nippon India Mutual Fund

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