Looking for fixed income instruments? Are short-term and corporate bond funds for you?

Kunal Shah

The Monetary Policy Committee (MPC) has maintained status quo on rates (5-1) in line with consensus and our expectations; however, the guidance was less dovish than what was largely expected. The drop in Q1 growth rate at 5.7 percent had opened the debate on some form of stimulus required to kick start the economic activity, specially the investment cycle. MPC maintained the neutral stance and remains purely data dependent for future actions.

MPC lowered its FY18 growth projections sharply to 6.7 from 7.3 percent, members acknowledged the possibility of widening of output gap but preferred to wait for more data to ascertain whether headwinds are transient or structural, MPC also believes growth revival is contingent on government’s steps in bank recapitalisation, fast rollout of affordable housing scheme & revival of stalled projects.

On inflation front, MPC has revised up the inflation projection marginally to 4.2-4.6 percent range from 4-4.5 percent citing jump in crude oil prices and core inflation print due to HRA hikes; the last inflation print for August was at 3.4 percent. Members projected stable food prices in future but see upside risk in overall inflation due to core and fuel component, inflation risks are also seen due to farm debt waivers and possible fiscal slippage at the central level.

The likely upside risks to inflation has clearly caused MPC to maintain cautious stance, and not cut rates further. Governor also mentioned the central bank believes economy will have cyclical upturn in quarters ahead and hence, doesn’t want to ease at this juncture till it’s believed the slowdown is structural and not transient.

We believe the inflation trajectory will be the key variable to gauge the direction of RBI’s rate, if the inflation prints in coming two quarters are sub-4 percent and core inflation remains in the range of 4-4.5 percent we can expect RBI to cut rates by another 25 basis points.

Bond markets were already under the fear of fiscal slippage and rise in supply of bonds; however, yields were soft in anticipation of dovish guidance from RBI. High realised real rates were also seen as trigger for rate reduction. RBI policy statement will be taken negatively by the markets and yields may remain the in the range of 6.55-6.75 percent till clarity on fiscal mathematics are clear. Markets will be watchful of movement in crude prices, CPI prints for more cues.

Foreign capital flows will also be key factor in determining bond yields in the near term, nominal yields on government bonds (6.7 percent) is the highest among the regional markets offering highest real yields. FPIs have invested nearly USD 19.5 billion this calendar year into rupee debt instruments. The macro-economic stability and inflation fighting central bank has added lot to the credibility. With low foreign ownership of securities and strong fundamentals Indian debt is preferred in the region.

Outlook on Bond Funds:

For a while now, we have been suggesting the moderation in return expectation from bonds funds specially the duration funds, the high teen returns of past couple of years may not be repeated as much of the easing cycle is now behind us. One more unknown variable for bond markets currently is government’s plan for fiscal stimulus, if any and its size. Nonetheless, we still believe that inflation trajectory will be key variable to determine rate moves. If inflation surprises the system by stabilizing below 4 percent we can expect some more easing of interest rates from the central bank.

Given few near-term uncertainties, we see the bond fund space specially the short-term category and corporate bond funds in the sweet spot, the lower and stable inflation will ensure reasonable risk adjusted returns from the category and certainly returns higher than traditional bank deposits.