Focus on right time horizon for debt funds
Premium- 90% returns come from carry, which has moved up sharply, the past year
A 220 basis points change in the inflation projection by the Reserve Bank of India (RBI) over the last four months is perhaps the most striking example of the fast-changing macro landscape that we are dealing with. What started as a consensus view around inflation being transitory and driven by temporary supply side disruptions has now changed to an acceptance of the stickiness in these price pressures.
That said, there is good news on the horizon. Central banks, including the RBI, have accepted the new paradigm and have clearly shifted focus from nurturing growth to restricting inflation. Governments have stepped in with fiscal measures to tackle supply- side price pressures. This may not resolve supply side disruptions and demand-supply mismatches in the short term, but will impact incremental demand and price pressures over the medium term as we get in the restrictive monetary policy regime.
In the Indian context, the RBI and markets are now almost in sync in terms of both inflation and growth projections for FY 2023. The market, while having itself underestimated the extent of these pressure points earlier, has significantly repriced itself since the time inflation expectations moved northwards of 6%. Multiple future rate hikes have been factored into bond yields, along with at least a part of additional pressure that could accrue due to demand-supply mismatch in the sovereign bond space. With the RBI now in sync, the expected rate hike trajectory will broadly be in line with market expectations and what has been priced in. That means, the scope for negative surprises has reduced.
Options for investors
Fixed Income funds are a basket of products that offer various combinations of potential risk-reward for investors and require relevant holding periods for the returns to materialize. Even in the worst of situations, there are products at the extreme shorter end such as liquid and ultra-short duration category funds that offer a conservative option even for short periods, albeit with limited return potential. But with the scope of negative surprises coming down, allocations in categories such as ultra-short/money market/low duration funds for a holding period of 3-12 months and short term/banking and PSU/corporate bond fund categories from an 18 month + perspective are more palatable from a risk-return perspective. The longer end of the yield curve, having also repriced meaningfully, may still evolve for some more time till investors get more comfortable around the demand-supply dynamics in the G-sec markets. We are reaching levels where absolute yields can drive investments even in this space over the next 6 months. Similarly, target maturity ETFs/index funds have seen significant improvement in carry (portfolio yields), and continue to offer better returns visibility, if held till maturity.
Over the right holding period horizon, almost 90% of the returns in fixed income come from carry, which has moved sharply in the last 12 months. While the noise around high inflation numbers and consecutive rate hikes will remain, what matters from an investor standpoint is their holding period returns. While one doesn’t expect yields to start down-trending meaningfully anytime soon, barring unforeseen macro events, what matters is the cushioning already available to handle such moves since carry has improved. The key then in this environment is not to downplay risk, but to recognize the buffers already built to manage that.
Lastly, fixed income outcomes, barring an element of credit risk, are always driven more by the right investment holding period, rather than short-term volatility in rates. This is especially in markets such as the current one which has tried to price in a lot of negatives. So, focus on the right product basis your investment horizon and it should play out reasonably well in the near-to-medium term.
Amit Tripathi is CIO-fixed income investments, Nippon India MF.