By Siddhant Mishra
As India and the world prepare for a pause in rate hikes, the focus has shifted towards a sustainable pro-growth policy by central banks.
What’s your outlook on the debt market in 2023?
Most of the turmoil, interest rate volatility and policy normalisation is nearing completion. People will now focus on how long it takes for the cycle to turn. Rate hikes impact the three key variables of inflation, unemployment, and growth. Once central banks see inflation coming down to targeted levels, they could go for cutting rates.
Hence, the key theme for 2023 will be how long central banks stay on a pause, having achieved the terminal policy rate, and what markets are pricing in as regards the next phase of the rate cycle — when the cuts happen and by how much. Therefore, fixed income may start looking more attractive given the absence of a negative impact in terms of rising yields, and nominal yields could also look favourable. Investors could start getting a positive real rate of return, which has eluded them since the last couple of years.
Keeping in mind the volatility, what trend do you see during the first quarter?
If we look at the 90-day rolling volatility in bond prices, they will be much lower on an average in 2023. Looking back, in 2022, we went from inflation not being a worry and central banks expected to be easy-going in terms of policy normalisation to playing catch-up and front loading rate hikes.
There is an exit from overnight/short-duration funds towards longer-duration ones. What explains this shift?
Investors don’t expect rates to rise further. The curve is currently flat and has priced in a certain level of the repo rate. It makes sense for investors to add a bit of duration, as rates are more favourable. For example, a 5-year G-Sec fetches you a return of 7.2%, while the one-year forward inflation is 5.25-5.50%, thus giving you a 200-bps real rate of return, and beating inflation on the sovereign curve.
Second, the cycle has to eventually normalise towards a pro-growth level, which would benefit investors with a three-five-year horizon. That gives you a big upside, which you won’t get from an overnight or liquid fund, because the delta of capital gains from a bond portfolio comes with a fall in rates.
YTMs are yet to peak, with another round of rate hike being expected. How will that impact long-duration funds?
That has been factored in; the only surprises could be if the rate hike doesn’t take place, which would be a positive, or if they underestimate inflationary pressure and hike rates more than expected. Investors shouldn’t wait for something that has already been discounted because our markets are forward-looking.
FPI investment in equities has somewhat revived, but debt is still showing outflows. Where does the gap lie?
FPIs look at emerging market debt from the prism of a decent positive spread, real policy rates with respect to the home currency and how the EM currency behaves. India hasn’t been attractive on any of these parameters.
Consider the relative rate-hiking cycle. A US two-year Treasury earns you about 4.25%, while an equivalent two-year Indian treasury would give 6.8-7.0%, thus giving a spread of 275 bps roughly. The reality, however, is that the annual depreciation in the currency has been 8.5% this year. Hence, the rupee depreciation has nullified the higher yield a dollar investor would otherwise earn, and the net dollar returns would be deep negative.
Which category of funds and time horizon would you recommend?
Seeing the way the yield curve has flattened, the spread on the sovereign curve is hardly 10 bps, which is not giving much by taking on a longer duration. Something in the short-to-medium category would be appropriate. When the conviction increases — likely to happen sometime next year — and there is talk of rate cuts globally, that’s when people could consider taking longer durations.
High valuations, China Covid scare and volatile crude prices could keep markets shaky. Could the debt market benefit?
There is a strong case for fixed income as all drivers are there. Nominal yields are back to the level where they give you a real rate of return. With inflation coming down, the real rate is widening. Finally, the possibility of rate cuts — all the pain inflicted by tightening of rates seems to be behind us.