Home / Money / Personal Finance /  What must debt investors do in current market?

Globally, the Russia-Ukraine war and domestically, the Budget and the outlook for monetary policy are creating uncertainties. Due to the lockdowns that started two years ago, the domestic macroeconomy has been struggling. But the economy was running weak even before we hit the pandemic. As a result, the three-year compound annual growth rate (CAGR) of real GDP was barely above 1% for the first nine months of this fiscal. This poor growth has been accompanied by relatively high inflation, which for the past two years has been averaging close to 6% — a situation that is close to stagflation. It is understandable, then, that the focus of policy, both fiscal and monetary, appears to be on reviving growth.

The fiscal policy might be an appropriate tool to push real growth upwards. Monetary policy, on the other hand, affects nominal growth. By keeping inflation elevated, one gets the sense of growth, but it runs the real risk of entrenching high inflation expectations. As a consequence, the market expectation of the future course of interest rates has risen sharply in recent months.

Added to the complex domestic situation is the war in Europe. The extreme price increases (in some cases doubling or more) in several commodities in recent days has the potential to disrupt our economy as we are a net commodity importer. Petrol and diesel prices need to adjust, and perhaps so too will food prices. The upshot is a sharp weakening of the rupee to an all-time low against the dollar.

The near-term worry is about the rise in commodity prices and their impact on inflation. However, a war is a needless destruction and in the medium-term is more likely to prove deflationary than inflationary. The impact on both counts will be limited if this is a short conflict as opposed to a long-drawn crisis. Assuming that the invasion ends in short order, we should expect to see some normalcy in commodities soon. We should expect volatility in the near term, but the focus will shift back to domestic macros in the coming months.

As inflation remains high and with some upside risk from the currency depreciation and commodity prices, we should expect the Reserve Bank of India to eventually start raising interest rates. The large government borrowing programme will also start to affect bond yields as the market will find it difficult to digest the supply of bonds. We would like to be defensive in this environment preferring lower duration.

As growth returns, the macro environment for credit (i.e. non-AAA bonds) is likely to improve. This segment in our view is already one of the strongest performing segments thanks to higher yields and lower duration. We expect this to continue through the rate cycle.

Investors should look at funds where the duration of the portfolio is less than the intended holding period. Duration represents roughly the interest rate sensitivity or the “re-pricing" tenor. In a rising interest rate scenario, if the holding period is greater than the duration, the effect of re-investment (i.e. maturity of bonds getting reinvested into new higher-yielding bonds) dominates the effect of marking-to-market (i.e. lowering of value due to rise in rates).

For a short-term investor, the appropriate segments may be overnight, liquid, money market, and ultra-short-term debt funds. Investors with a medium-term horizon (say 6 to 24 months) may want to consider low duration, floater, and short-term segments. Investors with greater than 3 years’ horizon should consider allocating to longer duration schemes such as target maturity funds but also look at taking on some credit risk through credit risk schemes as well as other schemes which have an active allocation to non-AAA bonds.

R Sivakumar is head at Fixed Income, Axis Mutual Fund.

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