In the December monetary policy review, Reserve Bank of India (RBI) governor Raghuram Rajan gave the industry and individuals hope by saying that the central bank could ease interest rates early next year, which could be even outside the policy review cycle, if the downward momentum in inflation continued.
The central bank’s next policy review is scheduled for early February and most expect the RBI will either cut interest rates then or wait until April.
On expectations of a rate cut, debt investment avenues, especially long-duration investments, have found large inflows from retail investors.
Fresh investments: With falling inflation and crude around $60 a barrel, the economy hasn’t had anything sweeter in a long time. Some leading banks have cut deposit rates by 25 basis points (bps) without lowering lending rates.
With an investment horizon in excess of 18 months, investors can put money in bond funds without compromising on the quality of the issued paper. With bank interest rates expected to come down, the reinvestment risk for bank fixed deposits is high. In such a case, investments in bonds funds are recommended. If the holding period can also be increased to over three years, the yield, after long-term capital gains tax, could be at levels similar to those seen in early 2012.
Existing investors: Investors already invested in bond funds have had a roller-coaster ride. After seeing double-digit returns in the early part of the investment cycle and a sub-optimal, negative return over July-December last year, investors can now look forward to returns similar to those in the past. From the negative territory, returns have inched slowly towards double digits. So, patience is likely to be rewarded.
The tax-free bonds issued by the government have delivered an annualised yield in excess of 18% and, in some cases, even higher. With rate cuts expected, the yield is only going to soar — another trading opportunity for those wanting to benefit from rate cuts over the short term.
Returns from ultra short-term bond funds would also be low compared to current returns. But, with bank deposit rates expected to trend lower, there may not be much to choose. However, much of the action is expected to be in the bond fund and gilt fund category. Interestingly, gilt funds reported the highest net inflow in 15 months in November because of a falling yield and expectations of a rate cut by RBI early next year. For the risk-averse, however, bond funds are better than gilt funds.
Though headwinds for debt investments are unlikely, investors must ensure that short- and long- term investments are not mixed.
Duration and accrual funds are expected to deliver handsome returns in anticipation of RBI rate cuts. But do note that Black Swan events (as seen in July 2013) can change the equation. With some caution, debt investments in bond funds can be a welcome addition to the overall portfolio.
By Brijesh Damodaran
The writer is managing partner, BellWether Advisors LLP