Back'Look at medium duration debt mutual funds to earn slightly higher returns'
Medium term products with an average duration of 4-5 years can tactically leverage the attractive spreads in the upto 10 year segment covering both bonds and G secsInvestors could hence add some allocation in this category to their portfolios.
PremiumBy Kumaresh Ramakrishnan
The newly set up MPC delivered a status quo on rates, noting pressures from inflation and prevailing economic uncertainty. However, the issue of demand destruction in wake of the pandemic came to the fore in setting the policy narrative. RBI’s GDP forecast for FY 21 at negative 9.5%, prioritized growth to be addressed urgently while ignoring high ‘transient‘ inflation prints. Monetary measures included widening the liquidity pipeline, a reassurance to enforce yield stability through orderly market conditions and supporting banks to lend more.
Markets and yields
Even before rate cuts started in March 2020, yields have been steadily falling. Govt bond yields have had a steady downward decline. From almost 8.15% levels in October 2018, they are now down 225 bps in exactly 2 years to under 6%.
Presently, reverse repo (which is the operative rate) is at a historical low of 3.35%, while the spread of the 10-year Government bond yield over this rate at almost 260 bps is a historical high. In the past, under steady market conditions, this spread has ranged from 50 -100 bps. The high spread is the achilles heel for the Central Bank hindering effective yield transmission.
This spread is likely to be tracked by the Central Bank, and its management is key to ensure credit availability cheaply and adequately to all eligible borrowers. This high spread is sticky and symptomatic of other ills in the system such as poor health of PSU banks, still high level of NPAs, risk aversion in the system all of which will take a while to cure. As such RBI is likely to keep up the barrage of liquidity to compress this spreads while other structural improvements occur.
This historically high spread also throws open attractive opportunities to investors over the medium term. Since all credit is priced off the Govt bond yields (which is the risk free rate), effective spreads at 350 bps for a 10 year AAA corporate bond, is even more attractive.
The efficient frontier
While inflation remains a worry, we expect it to partly subside as the monsoon seasonality ends and fresh harvests hit the market. Supply side inflation may take some more time to iron out and may prevail.
However, given RBI’s willingness to not over-react at this juncture, means that markets are unlikely to face any tightening actions or steps in the foreseeable future. In fact, RBI’s comfort in shifting to the reverse repo as the operative rate (which is 65 bps below the repo rate at 4%), signals the imperative on keeping the liquidity taps running. Rarely have we seen reverse repo being converted to the operative rate (the last being after the 2008 GFC), and this has important takeaways for investors.
In this context, we visualize the incremental risk of moving a little longer on the yield curve as limited, without adding commensurate volatility risk. Medium term products with an average duration of 4-5 years can tactically leverage the attractive spreads in the upto 10 year segment covering both bonds and G secs.
Products in the current environment
Short duration category (duration of 2-3 years) funds such as Corporate bond funds and Banking PSU funds have done well delivering around 7.75% and 8.5%, annualized in the last 3 years, beating both bank FDs and administered rates. On a post-tax basis, these funds have also beaten AAA tax free bonds by 100-125 bps. They have also beaten medium term funds, which have delivered under 6%.
Medium term funds (duration of 4-5 years) do carry higher volatility, but the risk-reward is in their favour at present. Benign macro conditions of weak growth, surplus liquidity and possibility of one more rate cut are strong tailwinds that presently support this segment. Investors could hence add some allocation in this category to their portfolios.
We remain cognizant of some looming risks such as a record general govt deficit and lack of enough visibility on growth returning which has implications for fiscal deficit in the coming years. Historically, yields in India have also been more prone to inflation. Hence pure long duration products (Gilt, Dynamic, Income funds) can be highly volatile especially when CPI is still around 7%, and should hence form only a smaller holding and only for those with some risk appetite.
(The author is CIO – Fixed Income, PGIM India Mutual Fund. Views expressed are his own.)
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