Once perceived as safe and stable, bonds are now usually scrutinised in greater detail and caution. 2016 was an uncharacteristically good year for Indian bonds; it was one of those rare periods when Indian bonds outperformed Indian equities.
Saurabh Jain & Aditya Sharma
Once perceived as safe and stable, bonds are now usually scrutinised in greater detail and caution. 2016 was an uncharacteristically good year for Indian bonds; it was one of those rare periods when Indian bonds outperformed Indian equities. Naturally, heading into 2017, return expectations from local bonds were high, but equities have outperformed bonds significantly in first half of this year. A cautious central bank, dynamic inflation and an uncertain global environment have all contributed to Indian bond market’s volatility. Earlier this year we cautioned bond investors to be prepared for more modest total returns, punctuated with volatility and greater focus on ‘real’ (inflation-adjusted) returns rather than ‘nominal’ (absolute) returns. We revisit this view and also look to the road ahead.
So, what has changed since the start of this year. First, inflation (retail) has dropped to record lows. The June reading was about 1.5% (year on year), an unexpectedly low number and a new record low since the series began in 2012. A large drop in food prices has been the key reason for the plummeting inflation, and what appears to be the onset of another favourable monsoon suggests inflation is expected be lower for longer. Amid such benign inflationary expectations, RBI (and eventually the banks) is expected to reduce interest rates. Resultantly, both deposit and lending rates could come down, as would bond yields.
Second, the global inflows into local bonds have been significant. Foreign investors have bought about $16 billion worth of rupee bonds so far this calendar year; this is almost twice the net amount invested in Indian equities over the same period. A strong and stable rupee, along with high yields (relative to other emerging markets), has driven rupee bonds’ appeal.
RBI acknowledged that inflation has undershot its expectations and consequently revised its inflation (and growth) forecast lower. This acknowledgement from the central bank is being construed by most as a precursor for a rate cut in August. Sentiment towards bonds improved and yields on long-term bonds (which are more sensitive to interest rate changes) fell sharply. This was one of the key reasons long-term bonds outperformed their short-term counterparts in the last quarter (ended June 2017).
What should investors expect going ahead?
We expect lower nominal (absolute) returns, but higher real (inflation-adjusted) returns. While interest rates on bonds have softened, inflation has dropped at a faster pace, boosting real (net of inflation) returns to investors. To cite an example, the three year AAA index currently yields about 7.2% and the last CPI (retail) reading was 1.5%, providing a real return of about 5.7% to the investor—amongst the highest positive real returns witnessed in recent years. For context, bond investors were burdened with negative real returns (ie, inflation exceeding bond returns) for the large part of the last decade, eroding wealth. Positive real returns were restored only from 2014 and are now close to historical peaks.
Managing interest rate risk will also be a key, in our view. Bond prices (and returns) are inversely related to interest rates, ie, falling (or rising) interest rates generally imply rising (or falling) bond prices. The price rise (or fall) is greater for long-term bonds (which are more interest rate sensitive), than short-term bonds. Therefore, long-term bonds tend to be more volatile in environments of sharp interest rate movements. Thus, we believe it is important to keep a close watch on interest rates. Adding short-term bonds can reduce (though not eliminate) interest rate risk, but this comes at the cost of somewhat reduced yields.
Credit risk is also important. A superior credit rating, such as AAA, is generally reflective of a greater ability to repay debt. A lower credit rating, such as A, may offer higher yields but at higher associated risks. In the uncertain demonetisation and the GST era, we believe it may be prudent to stick to a stronger credit profile. Predicting future policy rates has always been challenging. While the market now appears to be pricing in a RBI rate cut in August, the chances the RBI maintains a status quo are not zero. From an investment perspective, we believe the focus should be on using appropriate positioning in terms of obtaining a reasonable ‘real’ yield and managing credit and interest rate risk rather than pinning hopes on policy moves alone. Hope for the best, but be prepared for disappointment.
With increased volatility in first half of 2017, we believe investing in bonds has become more challenging this year. Looking ahead, we believe we need to be prepared for more modest total returns, punctuated with volatility, but a focus on ‘real’ returns is likely to help best guide investment decisions.
Jain is executive director, head of investment strategy and sales and Sharma is director, investment strategy, Standard Chartered’s Wealth Management unit. Views are personal