The RBI has been mopping up excess liquidity and has kept the repo rate unchanged. Given the emerging growth-inflation situation, what’s your outlook for the bond market in 2022?
The mop-up through short-term VRRR (variable rate reverse repo) auctions may narrow down the gap between the overnight and repo rates but won’t lead to a permanent reduction in core liquidity conditions. This has a bearing on lending behaviour and lending rates across the system. The fiscal story is incrementally positive, but the focus has clearly shifted from frugality to maintenance, so we don’t expect any large consolidation in the next 12-18 months.
The RBI, like most other global central banks, is comfortable with negative real rates for now, till it is convinced on growth sustainability and wider economic participation. It would be comfortable with a near-term 5.0-5.5 per cent CPI reading, provided the glide path is in the right direction.
We would conclude a picture of benign liquidity conditions, slow normalisation and moderate final repo rate in the current up cycle. The longer end of the yield curve will be capped by improving fiscal conditions, favourable demand-supply, and RBI support. Comparatively, the curve will flatten through FY 2023, but should remain steep compared to historical averages.
The tail risk here is the external account, which may bear the brunt of a negative real rate regime. The above conclusion is based on the hypothesis of limited widening of FY 2023 current account deficit.
What debt fund categories should one invest in?
The market will try to pre-empt the RBI action and keep readjusting back as the RBI will most likely adopt a slow normalisation path, leading to a volatile market within a range. In a benign liquidity environment, carry will play a large role in overall returns.
The steepness in the curve would give enough protection over the right holding period. All allocations below 1 year should be restricted to the ultra-short/low duration category, and allocations beyond 18 months should be done through short term bond fund/corporate bond fund type of intermediate duration portfolios.
The longer end of the portfolio, though rich in absolute terms, is advisable only for holding period horizons of 4 years and above.
Target maturity funds offer safety and return predictability. But with interest rates expected to go up, do very long maturity TMFs make sense ?
The argument in favour of a target maturity (roll-down) strategy is to enhance carry and capture the steepness in the curve. The argument against it is faster liquidity normalisation than what is priced in by the curve since there is still uncertainty due to many moving macro factors. On balance, capturing the carry with reasonable visibility in TMFs is a good risk strategy in our opinion. But like with all other strategies that give higher visibility and insurance, the investors may incur some opportunity cost of forgoing potential additional returns, a fair trade-off in such an environment.
Also read : Gold 2022 outlook by Chirag Mehta of Quantum MF
After the massive outflows in 2020, credit risk funds have seen inflows in recent months. Should high-risk investors go for them today?
Non-financial corporate balance sheets are in the best of shapes currently. The financial services sector has also bounced back reasonably well, post Covid 2. Financial leverages are low, benefits of operational leverage are catching up and companies are running more than adequate liquidity. While the environment is still somewhat fluid, growth conditions and economic momentum are definitely trending higher. Industry leaders within sectors and sub-sectors are doing well.
On the other hand, the regulatory interventions since 2019 have de-risked portfolios from a liquidity risk perspective, and issuer concentration risks have also been reduced significantly. The approach of both industry players and rating agencies has been fairly conservative as well. The credit spreads, though not at their widest, are still healthy and pricing is fair for the risks investors are taking.
Hence, on balance, credit risk funds offer a more than fair investment proposition for investors comfortable with this space.