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Fixed Income - Way Forward For Investors

Most of the tailwinds that supported the buoyant growth in Indian fixed income markets seem to be tapering off now

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Much to the vexation of debt mutual fund investors, Indian Bond Yields have been going up across the board of late. Since its November '16 lows of 6.25% or so, the yield on the bellwether 10-year G Sec has risen strongly by nearly 125 basis points, hurting high duration funds such as long-term debt funds and GILT funds. In fact, it may be fair to say that Indian Fixed Income markets are in the clutches of a bear market right now.

Most of the tailwinds that supported the buoyant growth in Indian fixed income markets seem to be tapering off now. The U.S Fed has consistently been raising rates, global growth is picking up, inflation is back up to 5.21%, and crude prices have risen from $40 per bbl or thereabouts to $60. According to experts, for every $1 (Rs 65) rise in crude oil prices, the corresponding impact on the current account deficit is to the extent of $1 billion (Rs 6,500 crore).

The RBI, in its recent policy meet, sounded the alarm bells with respect to inflation. In the recent Union Budget, Finance minister Arun Jaitley set the fiscal deficit target for 2018-19 at 3.3% of the gross domestic product (GDP), to accommodate higher demand for expenditure - against the earlier target of 3%. "Apart from the direct impact on inflation, fiscal slippage has broader macro-financial implications, notably on economy-wide costs of borrowing which have already started to rise. This may feed into inflation," the Reserve Bank said.

At the same time, the credit environment seems to be improving, auguring well for accrual-oriented funds such as corporate bond funds and low to moderate duration, income-oriented debt funds. This has largely happened on account of rising commodity prices, which have benefited steel and metal companies, and a buoyant primary market, which has allowed companies to successfully deleverage their balance sheets in recent times.

What should the strategy be for debt fund investors right now? I have been advising clients to restrict themselves to low to moderate, credit-oriented debt funds since yields fell below 6.5% back in 2017/17. In January '17, I advised clients to switch out of duration funds and into accrual funds once yields approached the 6% mark here, a strategy that would have paid off richly.

I'll stick my neck out right now and say that a lot of negatives are already priced into the current yields, which are hovering in the 7.5% to 7.75% range. That's a sizeable 150 basis point spread over the Repo rate. A 50-60 bps spread between the two is a reasonable figure, but the current number is nearly thrice that - implying, in effect, that the bond market may have already priced in a couple of rate hikes! Any improvements into macroeconomic factors from this point on may actually help temper bond yields from current levels. It may be worthwhile to gradually (via SIP's or STP's) build an exposure of 25% to 40% to longer duration debt mutual funds in the next six to eight months; in effect, locking in current yields - which may continue to remain volatile for a few more months. Allocate the remaining 60% judiciously to credit opportunities funds, many of whose yields are now nearing the 10% mark.

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