With inflation showing signs of easing, there is a clear possibility of a rate cut on the horizon. The government’s fiscal consolidation roadmap and India’s inclusion in the Global Bond Index from June 2024 bode well for the Indian bond market and, thus, debt fund investors, too. Amit Tripathi, chief investment officer, fixed income, Nippon India Mutual Fund, in an interview with Kundan Kishore, sheds light on investment opportunities for debt fund investors in this scenario. Here are the edited excerpts:
Has the interest rate peaked of late? The last rate hike came in February 2023, and ever since the Reserve Bank of India (RBI) has been on a pause. Given that inflation has stayed within RBI’s upper tolerance band of 6 per cent for the last six months, when do you anticipate the next rate cut?
The policy rates have peaked and are headed directionally down. The timing and quantum of the down move will depend on multiple internal and global factors. From a policy rate perspective, the concensus is 50-75 basis points (bps) of rate cuts over the next 12-15 months. This, combined with incrementally easier liquidity conditions, would effectively translate into 75-100 bps of policy rate cuts over the same time.
How do you interpret macroeconomic trends, such as the government’s focus on fiscal consolidation, and their impact on the bond market?
The macroeconomic conditions, specifically the continuous quantitative and qualitative improvements in twin deficits (fiscal deficit and current account deficit) augur well for medium-term core inflation prospects and, hence, medium-term policy rates and interest rates as well. A reducing fiscal deficit combined with a falling current account deficit trajectory, as has been the case since financial year 2021-22, has led to incremental easing of core inflationary pressures in the economy. Lower core inflation automatically feeds into lower headline inflation and, in turn, aids lower interest rates. This is already visible along with the impending bond inclusion story to a fair degree on the longer end of the yield curve (10 years and beyond). The shorter end of the yield curve (1-5 years) could incrementally react much more positively to actual rate cuts and easing liquidity conditions over the next year or so.
Yields are on a downward spiral. Do you think the market has started factoring in future rate cuts?
The longer-end yields peaked out towards the end of 2022. Then they stabilised and declined over the last 12 months. This is a reaction to the improving trend in twin deficits, expected decline in headline, and core inflation and better demand supply dynamics in government securities (G-secs). While this trend is likely to continue in the medium term, the yields are likely to consolidate in a narrow range of 10-20 bps around the current levels in the near term.
The short-to-medium part of the yield curve, after a volatile 2023, has now started reacting favourably to both the expectation of rate cuts and the incremental easing of liquidity conditions. However, the reaction here has been relatively modest, and one may expect more positive reactions as we move closer to the actual start of the rate cut cycle.
How would the inclusion of government bonds in the Global Bond Index impact the Indian debt market?
The direct impact of this inclusion is in terms of better demand-supply balance in government bonds and it has a corresponding positive impact on the demand for high-grade corporate bonds as well.
Over the medium-term, the presence of global investors adds an important source of countercyclical demand, especially when demand from domestic investors is weak.
Qualitatively, the Bond Index inclusion also makes the issuer, in this case the Government of India, more responsive and disciplined in terms of managing the fiscal deficit and the resulting bond supply.
Where do you see investment opportunities for retail investors? Are long-duration funds attractive now, given the anticipated rate cut and their sensitivity to rates?
The medium-term story is favorable owing to both macro improvements and better demand-supply equation. In the very short term, the yields are likely to consolidate in a narrow range of 10-20 bps. However, any investment horizon beyond 12-18 months needs to have a reasonable allocation to the longer end as well, given the secular improvement in the twin deficit parameters, which will lead to a softer rate regime ahead.
Over the next 12-15 months, risk and return is more balanced in the short-to-medium part of the yield curve given the partial run-up already seen in long duration debt funds. Products, such as short-term debt funds, corporate bond funds and banking and public sector undertaking (PSU) debt funds are well positioned to capture this trend. However, any investment horizon beyond 12-18 months has to have a reasonable allocation to the longer end as well. This will lead to an overall softer rate regime going forward.
How convenient is direct debt investment vis-a-vis mutual fund alternatives?
There are multiple ways to define convenience. These could include ticket size, ease of access to a diverse set of issuers in terms of potential returns and credit quality, ease of entry and exit, impact cost of entry and exit, management fees forgone versus hidden costs, healthy diversification versus forced diversification, risk management versus potential risk and potential return maximisation, among others. In general, for most of the parameters which have to do with ease, efficiency, transparency and optimum risk return, mutual funds score over direct investments. However, risk-seeking investors may find the direct investment or portfolio management service (PMS) route more appealing when they are trying to enhance the risk profile of their debt investments.
The taxation change on debt mutual funds (MFs) was implemented a year ago. How lucrative are debt MF investments now compared to fixed-income instruments?
There is a level-playing field from the taxation perspective in debt mutual funds versus direct bond investments or other traditional products, such as fixed deposits. At the margin, debt MFs are still more tax-efficient as there is no tax outgo till the investor actually puts in a request for redemption. In contrast, the investor has to pay tax on each cash inflow in all other debt and FD investments. So, the longer you stay invested, the higher is the efficiency since your tax incidence keeps getting postponed.
But it would be short-sighted to weigh the pros and cons of debt or equity MFs on the basis of relative taxation. There are much more important return enhancing and risk mitigating efficiencies that diversified debt MF schemes bring to the table, such as market expertise, market-linked returns, minimal impact costs, ease of access, higher transparency, product segmentation and so on. All these make debt MFs far superior to FDs and direct bond investments.
Investors have shifted their focus to hybrid funds following the tax changes. Can hybrid funds be a substitute for pure debt funds?
The tax change led to many investors investing in balanced funds as a substitute for debt funds, since they offer indexation benefits and have some part of their portfolios invested in fixed income instruments.
It is important to highlight the significantly different risk and return profile that these two categories have, given that the minimum allocation to equity in any balanced fund is more than 50-60 per cent. That essentially makes balanced funds a conservative equity fund offering and not a substitute for debt funds.
The portfolio balancing and diversification decision should not be driven by tax considerations, and the core debt allocation in any investor portfolio should be made only through pure debt schemes.
Investors now have a choice of passive debt funds, too. In such a case what should be the investment strategy?
Passive funds are mostly cost-efficient, but come with a static asset allocation and a static reducing duration profile. In that sense, there are inbuilt handicaps from an efficiency perspective that an active fund can generate. Passive funds work best for investments of specific tenure and/or as a tool to increase or decrease your portfolio duration in a cost-effective and seamless manner. In that sense, they are never a substitute for core debt allocation through open-ended funds. Rather they can complement this core debt allocation for specific purposes for specific time periods.
After the IL&FS fiasco, how have things changed in terms of risk measures?
The IL&FS and allied fiasco brought home many firsts, such as credit default in AAA-rated issuers, along with significant management quality issues even in large corporate houses or groups, along with opacity in issuer level disclosures. The regulators and industry have worked together to address many of these issues at a systemic level. Additionally, all large asset management companies (AMCs) have beefed up their credit processes, and there is additional focus on avoiding concentration risks. There is a huge premium on management quality, and AMCs have shunned away from investing in issuers where there are issues around management quality and opacity in data and business models. The focus is better risk-adjusted returns by identifying good credits early, using superior in-house credit research, and to avoid investing in any business with questionable business practices at the cost of foregoing optically higher yields.
kundan@outlookindia.com