Debt is on the cusp of a rebound

Written by Nimesh Shah | Nimesh Shah | Updated: Oct 27 2014, 07:45am hrs
Currently there is fear in the debt market. Fund flows into debt funds have turned negative. Debt funds medium-term performance (the last two years) has fallen below the average. Besides, given that the equity markets are doing well lately, investors are overlooking debt as an important asset class.

That is precisely what investors should not be doing now. Debt funds are on the cusp for a strong rebound. There are several reasons going in favour of the debt market now. Macro-economic conditions have improved considerably this year, paving the path to a recovery. This has all the makings of a broad structural rally in the bond market in the next two or three years.

Key indicatorsthe current-account deficit (CAD) and inflationindicate better parameters. Besides, fiscal consolidation is high on the agenda of the government. These suggest good days for the bond market. Besides, debt and income funds should be an essential part of ones portfolio as a key diversification strategy.

Increasing savings to benefit the debt market

In 2004-08, a sharp rise in savings rates led to a sustained fall in interest rates (savings rates are negatively correlated with interest rates). Now, after a long time, real interest rates have inched towards positive territory. As inflation has been sliding lately, investors are likely to increase their savings rate. This would spur bank deposit growth, which could see benign bank lending rates in the next few years.

Besides, theres 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 conditions and not facilitated by the Reserve Bank of India (RBI). All this should keep bond yields in check and at lower levels in coming quarters.

In fact, ahead, debt investors may see interesting times. The possibility of falling interest rates and the trend in inflation are likely to see bond prices rise in coming years. In September consumer price index (CPI) inflation was down to 6.46%.

Better macro indicators

The current-account deficit (CAD) considerably improved in the second half of FY13, narrowing from 4.8% to 1.7% of GDP in FY14. This key indicator strongly co-relates to broad interest rates. A falling CAD indicates interest rates are likely to fall. Interest rates in Indonesia, Japan and Italy declined when their CADs contracted considerably.

More pertinent, lower inflation increases the real rate of return in the hands of investors. In the last few months, inflation appears poised to shift down, and debt-market yields could soften in coming quarters. The 10-year G-sec has been hovering around the 8.5% mark but 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 due to RBIs strong fiscal policy, inflation in India should begin to ease in the next few quarters.

Another sign of improving macros and which could have a huge impact on the debt market is the governments commitment to reducing the fiscal deficit. The government has proposed slashing the fiscal deficit to 3% of GDP in the next three years.

Rationalising subsidies and reducing revenue expenditure can further reduce inflationary pressures. Moreover, broad-basing taxes would improve the tax-to-GDP ratio. Besides, an early introduction of the (goods and services tax) GST could accelerate real GDP growth, and supplement and foster fiscal consolidation.

Going is good for debt funds

Which is why debt funds are in a sweet spot. In fact, all different debt fund categories should benefit in this environment from short-term debt funds to long-term income and duration funds. Investors in short-end debt products can benefit from interest accrued in a debt portfolio and from a fund managers tactical exposure to longer-duration debt securities. Investors with a longer horizon can look at medium-term debt funds, which would benefit from falling interest rates.

And for those investors who can withstand short-term volatility and who want to pursue a more aggressive debt-investment strategy, long-term debt funds look poised to make the most by taking exposure in debt securities that mature over a few years.

One can take tactical exposure into debt depending on ones risk appetite, and invest in this asset class for the medium- to long-term. One of the biggest bond-market advantages - falling interest rates - is going to power the debt market going forward. So, grab this remarkable opportunity in the debt market now and play it for the next two-three years.

The author is MD & CEO, ICICI Prudential AMC