In recent months, Indian investors have been reminded of the fact that there is nothing very fixed about fixed income investing. Until March this year, the mood was bullish in the fixed income markets, with the twin deficits improving, global crude oil prices falling and inflation readings heading nicely south. This prompted the RBI to initiate its long-awaited rate cuts.

Between January and April 2015, the RBI slashed its repo rates by 50 basis points. But the bond markets pre-empted this with a big rally as the yield on the 10-year government security (G-Sec) dropped from 9 per cent in December 2013 to 7.6 per cent by March 2015. This helped gilt and income funds notch up bumper gains of 14-18 per cent over 2014-15, prompting a large horde of investors to pile on to them.

But the last three months have seen the bull party in bonds suddenly interrupted. With crude oil rebounding from its lows and the monsoon playing truant, bond yields have headed up instead of down, halting the rally. The recent spike in European and US bond yields has also triggered foreign investor pullouts from India. The RBI has added to the jitters by citing risks from a deficient monsoon to up its inflation estimate. It also slashed repo rates by 25 basis points, but cautioned that rate cuts were being ‘front-loaded’.

So, what has changed for bond investors and how should they position their portfolios for higher returns? BusinessLine spoke to some leading bond fund managers to arrive at an assessment.

Rate cuts will continue When the RBI first embarked on its rate cuts, bond market players were betting that the repo rate would drop by 100-150 basis points this fiscal. Not just this, they were expected to keep drifting down thereafter. During previous episodes of monetary easing, repo rates declined by as much as 375-400 basis points (2001-2004, 2008-09).

But those bullish expectations have since been tempered. The RBI has so far pruned rates by 75 basis points and most bond fund managers now expect another 25-50-basis-point cut to come through by March 2016. Rate actions beyond that, most feel, will now depend on factors such as Fed actions and trends in crude oil.

What’s the rationale for lower rates? For one, India’s macro factors are today far more supportive of rate cuts than they were in 2013 or even 2014 (See graphic). Sluggish industrial growth, low capacity utilisation across sectors and signs of weak demand in recent corporate performance also suggest the economy badly needs an interest rate kicker.

Two, while the RBI seems to be wary of inflation risks, bond managers think that inflation rates are likely to settle well below the RBI’s projection of 6 per cent by early 2016, offering room for further rate cuts. Today, with their inflation targets at 5-5.25 per cent, and the RBI targeting real interest rates of 1.5 per cent over rates, repo rates are expected to decline to 6.75 or at best 6.5 per cent by March.

Rahul Goswami, CIO-Debt at ICICI Prudential AMC, who sees scope for the repo rates to be cut by a further 25-50 basis points by March 2016, says- “Macros such as fiscal deficit and current account deficit are improving. On inflation, the last many readings have been lower than the expected trajectory. We believe that consumer price inflation is likely to be at 5.25-5.50 per cent by Q1 2016 — within the RBI’s projection of 6 per cent by January,” he says.

Can the deficient monsoon throw those forecasts out of kilter? Not likely, is the current view. CPI readings have dropped relentlessly in the last four months despite the crude oil spike and unseasonal rains.

The April CPI inflation was the lowest this year despite fuel prices being at a 12-month high and pulses shooting up 50 per cent or so. In the past, the connect between monsoon rains and domestic prices has been tenuous. It appears unlikely that domestic inflation numbers will trend up when globally farm product prices are in a meltdown. “The empirical relationship between monsoon and food output is not proven. Nor is the relationship between food output and food prices. Last year, in April-May, everyone was talking about El Nino and the severest drought in a decade. But look at what happened. It didn’t materialise,” points out Akhil Mittal, Senior Fund Manager at Tata Mutual Fund.

Expect less from gilt funds So, with further rate cuts of 25-50 basis points on the cards, gilt funds (which invest in long-term G-Secs) can still get investors to a healthy double-digit return if held for over a year. But investors should not expect an encore of 2014 returns of 18-20 per cent. Breaking down that NAV gain of 18 per cent, 8-8.5 per cent came in from interest receipts and as much as 10 per cent from capital gains, as market yields fell by over 140 basis points (9 per cent to 7.6 per cent). The 10-year G-Sec is today at 7.8 per cent. Given that repo rates may decline to 6.5-6.75 per cent at the most this year, with limited visibility thereafter, it is unlikely that gilts will enjoy a bull run of last year’s magnitude.

Any rally in G-Secs will also encounter speed bumps along the way. The recent jump in crude oil prices, for instance, is a reminder that not all macro indicators stick to an orderly trend. Even if domestic fundamentals are in good shape, given the significant FPI (foreign portfolio investor) presence in Indian bond markets, a US Fed rate hike or other global events can set off bouts of volatility (see accompanying story). “Today, compared to three years ago, the presence of FPIs in the Indian market is larger. You have $55 billion or so of outstanding money. Yes, compared to Thailand or Indonesia, where they own 40 per cent or so, India is under-owned by FPIs, at less than 4 per cent. But their flows do matter and global volatility can cause a spike in Indian bond yields,” says Rajeev Radhakrishnan, Head of Fixed Income at SBI Mutual Fund. The expectation that Indian G-Secs and bonds will offer a bumpier ride this year has prompted most fund managers to reduce portfolio duration in recent months. This suggests two things for aggressive bond investors who target double-digit gains from long-term gilt or income funds. One, with the next one year likely to be choppy, they may have to hold on longer to reap the rewards of a falling rate cycle. (In fact, holding debt funds for three years makes for better post-tax returns because of indexation benefits). Two, with the bond rally capped, timing your entry well is important. Buying gilt funds when 10-year G-Secs are at 8.5-9 per cent — the previous market top — may yield better results. Given unfolding risks, investors should stick to funds that have navigated at least two previous rate cycles and have been nimble at containing losses. Here, ICICI Prudential Long Term Fund, IDFC Government Securities Fund - Regular and SBI Magnum Gilt – Long Term fit the bill well.

Investors who are not really equipped to make such calls can opt for flexible bond funds such as Birla Dynamic Bond Fund, UTI Dynamic Bond and Tata Dynamic Bond, which have navigated earlier cycles successfully. They aren’t low-risk, but can save you the trouble of watching market yields like a hawk.

Careful on credit risks But then most retail investors do not really bet on gilt funds to make higher debt returns. Instead, they look for high-yielding corporate fixed deposits or NCDs. As it is FDs of lower credit quality that usually offer double-digit rates, this is quite a risky strategy. This is a particularly bad time to take on such credit risk too, with corporate performance deteriorating, leveraged businesses struggling to get out of debt and lenders shying away from risky borrowers.

For such investors, income and short term debt funds which hold a mix of AAA and lower-rated bonds offer a good alternative. They aren’t devoid of risk, but at least these funds are careful about diversifying their credit risk. Such accrual funds can get you to a 9 or 10 per cent return, without having to second-guess the direction of interest rates. In this space, investors can look for funds that invest in a mix of AAA and lower rated bonds, but restrict their portfolio duration to no more than three years.

The shorter duration can help contain both default and rate risk. Birla Medium Term Fund, Franklin India Short Term Income Plan and ICICI Pru Regular Savings are a few tried and tested funds that make for good buys.

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