The rally has been driven by a reversal in the negative sentiment among investors caused by a stable government at the Centre. The limiting of the fiscal deficit for FY15 to 4.1 per cent of the GDP as announced in Budget 2014-15 have given markets a reason to cheer. Also, the high-base effect, better supply management and pick-up in the monsoon, dissipated fears of a food supply-driven inflation. Thus, while inflation measured by the Consumer Price Index (CPI) stands at 7.96 per cent in July 2014, higher than the June figure, the larger inflation trajectory remains downward. In fact, the market expects the inflation to moderate faster in the coming months and reach well below the 8 per cent-mark by January 2015 as targeted by the RBI. Expectation of a better investment climate may see improvement in manufacturing levels; and help improve aggregate supply.
At the market level, the appetite from foreign institutional investors (FIIs) for Indian GSecs remains strong, with nearly $14 billion of net purchases in 2014. While this demand remains susceptible to exchange rate fluctuations, the RBI looks intent on smoothening foreign exchange volatility and is therefore mitigating the currency risk to some extent. Moreover, since the quantum of GSec supply in FY15 is largely similar to that of FY14 levels, we perceive that even at natural progression of M3 (a measure of money supply) and bank deposit growth, the appetite for debt must rise.
However, the downside risk to market sentiment remains mainly from the unforeseen events from the agriculture sector, the energy sector or from exchange rate volatility. Thus, while the food supply risk now seems to be declining, there is a high latent geo-political risk especially from events in the West Mediterranean (Gaza issues), in the Euphrates region (Iraq-Syria), in the North Black Sea (Ukraine) and even in the South and East China Seas as they pose a risk of a quick escalation. The unpredictable events in these regions can cast a long shadow on oil prices and exchange rates, thus impacting the debt market.
Having said that, the market sentiment is largely optimistic and perceives a gradual moderation in the policy stance, as well as in the interest rates. The liquidity conditions too are expected to ameliorate as the CPI inflation reaches a more tolerable threshold.
The offshore risk of the US Federal Reserve completely withdrawing QE3 stimulus and the likelihood of a rise in interest rates in calendar year 2015 is high; while its impact on the emerging markets is uncertain. The RBI therefore would be extra cautious in dropping rates till clarity on this emerges. However, one cannot expect to reach the desired growth rate of 7 per cent plus with the Government of India borrowing at 8.5 per cent plus. This ought to change in line with the drop in inflation. A softer interest rate environment is a must for long-term sustainable growth. From that perspective, duration funds could benefit immensely with the fall in yields.
For that reason, we believe that the gilt funds may provide double-digit return in a 12-14 month period. From this stand point, investors willing to maintain a similar time horizon and having the willingness to take low to moderate risk, can look at investing in long-term gilt / bond funds.
Also, since the liquidity rates have inched up in the money market, investors with a 1-3 month horizon can look at ultra-short debt fund to capture the high carry currently available. Short-term debt funds are advisable for such investors who are seeking partial duration exposure and have a six-month plus investment horizon. In this time frame, the low duration profile of the short-term debt products coupled with the high carry provides the needed fit for the investors.
It is also important to point out that the taxation structure of debt mutual funds has undergone a change in the Budget. The Budget altered the tenure for exercising the long-term capital gains in the debt mutual funds from one year to three years. At that, the long term capital gain tax rate for debt mutual funds was increased from 10 per cent to 20 per cent. Moreover, the method of calculating the dividend distribution tax has been changed to bring the effective tax impact on a par with the fixed deposits.
This move changed the investment incentive for the investors by removing the tax arbitrage due to net differential between fixed deposits and fixed maturity plans. By this initiative, the yield-based performance of the debt funds vis--vis the fixed deposits would become the more important element in investment decisions.
With long-term capital gains tenure now being extended to three years, a gradual shift in investor preference towards accrual funds is expected. Accrual funds typically tend to have a higher portfolio yield-to-maturity and therefore the stability of performance. This, along with the ready availability of liquidity, such funds provide a better product structure vis--vis similar financial products. Hence it is imperative that investors look at these mutual fund options, which could be complemented with traditional savings avenues such as bank fixed deposits. Therefore, investors could consider allocations to a combination of long duration bond funds and also accrual funds to be able to get better risk-adjusted returns on their fixed income portfolio.
The author is CEO, Kotak Mahindra AMC