Debt mutual fund investors are facing confusing times. The softer rates hadn’t exactly been music to their years. ETMutualFunds.com spoke to Kumaresh Ramakrishnan, CIO – debt, PGIM India Mutual Fund, for clues. “ When the outlook is confusing, it is best to keep things simple,” he says. Edited Interview.
Debt markets in the last few months have been negotiating pressures from stubborn and rising inflation on the one hand and worries stemming from another year of record supply of govt bonds. These have exerted an upward bias at the longer end of the yield curve. This is being offset by RBI’s continued and persuasive actions in the bond market through active buying in the secondary market and unconventional measures such as special asset purchase programs announced at the last MPC (G -SAP). In addition, RBI has repeatedly assured markets that it would maintain an accommodative stance, an orderly yield curve and keep liquidity in surplus to neutralise any yield pressures and calm market sentiment. In this backdrop long end yields have remained largely range-bound, though intermittently rising in response to inflation prints.
In our view the surge in covid cases would reinforce RBI’s resolve to stay dovish and emphasize priority of growth over inflation for the near to medium term. The policy language clearly refers to MPC’s objective of getting durable growth back before reconsidering any change in its stance. Minutes at the recent MPC also clearly highlight growth worries assuming priority for almost all MPC members.
Can we assume that lower interest rates are going to stay for some time but minus the usual euphoria in the debt market?
RBI has stated in no uncertain terms that it prefers lower rates to help the economy get back on its feet and return to durable growth. With rates being seen as a key element that can influence growth which is a priority, RBI has been employing the entire range of tools in its arsenal to get down rates / yields. Given its oft repeated belief of seeing the yield curve as a pubic good which is used to price every other form of credit we expect RBI to play an active role in managing yields through its participation in the secondary market.
What is your prediction for the 10-year yield?
While no levels can be predicted, clearly RBI ‘s stance so far has been unequivocal in this context. Yields on the 10 year benchmark for instance have been moving in a band of 15-20 bps. RBI has shown discomfort for instance when yields have shown a tendency to breach 6.20-6.25% levels. Spread over repo levels (at 4%), which is currently not the operative rate is over 200 bps and about 275 bps over the reverse repo. These are clearly way above historical spread levels, although the current context is also vastly different from the past. RBI though has expressed its discomfort at elevated term spreads as it has an impact on borrowing costs and investments / capex. Unless inflation deviates significantly from recent trends, we expect the 10 year benchmark g sec yields to remain anchored around current levels.
What does it mean for debt investors? Bad news for short-term funds?
Short-term yields are less correlated with long-end yields and depend more on liquidity conditions and term spreads with respect to the front end of the curve. Currently these are favourable and supportive for short-term funds. We remain mindful however of any impending changes to liquidity conditions and RBI’s initiation of liquidity normalisation operations.
Over time we expect two changes. One is the operative rate moving from reverse repo to repo. The second is the compression of the reverse-repo corridor from the current 65 bps to 25 bps representative of normal market conditions. Hence front-end yields up to one year could rise albeit gradually. Given the prevailing term spreads in the 2-3 segment, the yield widening in this segment is unlikely to be as high when the changes eventually happen.
Should investors try to get into long-term debt funds?
Long end yields have come off significantly in the last 2 ½ years. From a peak of almost 8.20% on the benchmark G sec (10 year bonds) in October 2018, G sec yields have dropped to 6% now, a fall of more than 200 bps. Yields were unusually high in 2018, reflecting corporate stress, risk aversion, macro worries and high oil prices that prevailed for most part of 2018. The correction in yields has been fast though not linear and are in line with the current growth – inflation mix. Given that inflation (both CPI and WPI) are certainly showing impulses in the last few months and staying at or over 5%, the scope for meaningful decline in long end yields is low. Also growth in the last few years has been subdued also reflected in the low bank credit growth rates of 5-6%. As growth picks up locally and globally, coming off the pandemic lows, spurred by the massive stimulus and pent up demand, GDP should rebound meaningfully. As such there is no case for long-end rates to come down significantly. Allocation to long-term debt funds should at best be a sleeve to the short term funds which should form the core of fixed income allocation for investors.
Should investors continue to bet on corporate bonds funds and PSU funds?
Corporate bond funds and PSU funds mostly invest in the mid segment of the yield curve in the 2-4 years. This segment enjoys stable yields with much lower levels of volatility in relation to long-term debt funds. Given our interest rate view, we would advise investors to have a core segment of their fixed income allocation in these products.
These are very confusing times for debt investors. What is your advice to them?
When the outlook is confusing, it is best to keep things simple. Investors should just do a few things in these times to wade through volatility without getting impacted. They should first get their asset allocation (between equity and fixed income) in place and stick broadly to it with minimal changes. Within fixed income, as stated earlier, we prefer the short term products such as the banking & psu and corporate bond fund categories which could constitute the core. Thirdly, investors should as far as possible align their product choices with their investment horizons irrespective of prevailing yields, to avoid being wrong footed if yield movements surprise abruptly and having to redeem at the wrong time. Over long periods of time, longer term debt products such as the dynamic and gilt funds have delivered the highest returns. However, investing horizons need to be commensurately longer for these categories to be able to pocket these returns. Investors are hence best advised to allocate a larger share to short term products to avoid volatility in the short term.