Good days ahead for debt investors

By Nimesh Shah
Managing Director & CEO
November 10, 2014
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It’s a suitable time to invest in the debt market for reasonable returns over the next 2-3 years

Debt funds may not be at the top of the mind for investors right now, but several reasons point out that debt is making a case for a structural rally. If you have been watching the debt market lately, the conditions may not appear to be the most suitable at first sight.

Inflows into duration funds have been negative in the recent past and the medium-term performance (over the past two years) of debt funds as a category has been below average. Given the way equity markets have been performing lately, debt funds are looking like poor country cousins and investors seem to be ignoring this well-placed asset class.

Yet debt and income funds remain an invaluable portfolio diversification and an essential part of one’s portfolio. The overall macroeconomic conditions have improved considerably this past year; paving the way for a recovery that has all the makings of a broad structural rally in the bond market in the next two-three years.

Key indicators such as the current account deficit (CAD) and inflation are showing signs of easing. Besides, fiscal consolidation is high on the agenda of the government, which suggests better days ahead for the bond market.

Macro indicators are improving

First, let’s take a look at the CAD, which has shown considerable improvement since the second half of financial year (FY) 2013. The CAD in FY14 has narrowed to 1.7% of the gross domestic product (GDP) from 4.8% in FY13. This key indicator is strongly correlated to broad interest rates in the economy. A falling CAD generally portends that the interest rates in the economy may be heading lower. Countries such as Indonesia, Japan and Italy saw a decline in interest rates when their CADs contracted considerably.

It’s even pertinent for investors to note that a lower inflation increases the real rate of return in their hands. Over the past few months, the inflation trajectory appears poised to head lower due to a host of reasons, which could see the debt market yields soften in the coming few quarters. The 10-year government security has been hovering around the 8.5% mark lately, and is showing signs of easing.

With softening international energy prices, better alignment of electricity prices with costs, moderating global commodity prices, and a stable rupee thanks to the Reserve Bank of India’s (RBI) remarkable efforts to keep policy rates at elevated levels, could reduce inflation in India.

Another tell-tale sign of improving macros, and which could have a tailwind effect on the debt market, is the government’s commitment to reducing fiscal deficit. The government has proposed that it would reduce fiscal deficit to 3% of GDP.

Rationalizing subsidies and revenue expenditure can further reduce inflationary pressures. To top it, broad-basing of taxes can improve the tax-to-GDP ratio. Besides, an early introduction of the goods and services tax (GST) could help accelerate real GDP growth, which can additionally supplement and foster fiscal consolidation.

More savings may see lower rates

Back in the 2004-08 period, a sharp rise in savings rates led to a sustained fall in interest rates as it has a negative correlation with interest rates. Now, yet again, real interest rates have inched towards the positive territory after long. As inflation is coming off lately, investors are more likely to increase their savings rate in the years to come. This can spur bank deposit growth, which, in turn, could see benign bank lending rates over the next few years.

Besides, there’s ample liquidity in the economy due to the substantial increase in inflows from foreign investors in both debt and equity. The banking system now needs to borrow considerably less from the central bank through the liquidity adjustment facility and other windows. This is a structural change in the liquidity condition and is not facilitated by RBI. All this could keep the bond yields in check and at lower levels in the coming quarters.

In fact, debt investors may see interesting times. The possibility of falling interest rates and trend inflation are likely to see bond prices rise in the coming years. Inflation based on the Consumer Price Index was down to 6.46% in September 2014.

Advantage debt funds

All this is expected to have a favourable effect on all kinds of debt funds—from short-term debt funds to long-term income and duration funds. Investors in short-end debt products can benefit from interest accruals in the debt portfolio and from a fund manager’s tactical exposure to higher duration debt. Investors with a longer horizon can look at medium-term debt funds that have potential to benefit from falling interest rates.

And for those investors who can withstand near-term volatility and who want to pursue a more aggressive debt investment strategy, long-term debt funds can be taken into consideration as it looks poised to make the most by taking longer duration exposure into debt securities.

Investors can tweak their fixed-income portfolios according to their risk appetite. As the bond market advantage of falling interest rates is likely to play out in the next few years, by adding more average duration, a debt fund can aim to generate returns when interest rates fall. At this stage, when investors are largely ignoring debt, we yet again believe that it is suitable time to invest in the debt market for long term returns over the next 2-3 years.

This article was published in Mint on 22nd October 2014 on Page 20.