AS the events of 2016 unfolded, the expectations on returns from the major asset classes, equity and debt, got modified accordingly. It is time now to be realistic about expectations on returns; let us see what we can expect from investments in debt in 2017.
The fundamental or economic drivers that shape returns from investments in debt are still positive. Inflation is within control. CPI inflation was 3.63% only on last count, in November. Inflation may move up slightly; the RBI expects it to be approximately 5% by March 2017 and 4.5% a year hence. This is on the lower side as per historical standards. Another relevant variable is the government’s fiscal deficit, which is part of the Budget exercise.
A lower fiscal deficit means lower government borrowing from the market to fund the deficit, which in turn means lower supply of fresh government bonds, a positive for the bond market. Lower deficit is also good for inflation. The government is committed to bringing fiscal deficit down. In 2015-16, deficit was 3.9% of GDP and the target is 3.5% of GDP in 2016-17 and 3% the year after. On the external trade front, where we look at the current account deficit, the situation is better than earlier, mostly because crude oil prices are lower than historical average.
Demonetisation is a positive for fixed income investments. Though people have faced hardship due to this, the disclosure of unaccounted income will lead to more tax collections, which means lower fiscal deficit. Our economic growth will take a hit for some time due to remonetisation, which also is a positive for fixed income investments. Low GDP growth rate is a reason for the Reserve Bank of India (RBI) to reduce signal interest rates, and lower signal rates are a positive for existing investments in debt. The RBI did not reduce interest rates in the review meeting on December 7, 2016, but there is scope for cutting rates by 0.25% to 0.5% in 2017.
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That brings us to the question, if everything is positive for fixed income investments, why should expectations on returns be ‘realistic’ in 2017? The reason is, the market has run ahead. The most popular tracker, the 10-year government security yield, was approximately 7.86% in February 2016 and has eased to 6.55% now. That is to say, interest rates in the bond market have already eased, with the RBI cutting rates since 2015.
The recommended investment category for 2017 is short term bond funds offered by mutual funds. The longer portfolio maturity categories of mutual funds—long term income funds and dynamic funds—are likely to be volatile in 2017. Short term bond funds will yield returns higher than liquid fund and will be less volatile than long term bond funds. In 2016, short term bond funds returned on an average 9.7%. Markets are always difficult to predict but broadly, in 2017, this category is expected to yield 2% to 2.5% lower. However, the context to look at is lower bank deposit rates, particularly after remonetisation, lower returns from liquid funds and likely volatility in long maturity funds.
The other option investors can look at are (a) arbitrage funds for tax efficiency and (b) direct investment in bonds rated AAA or at least AA.
The author of the article is Joydeep Sen, independent financial adviser and author