Debt funds have been on a roll in 2016. Top gilt funds have raked in hefty gains of 16-18 per cent thanks to the sharp fall in yields of G-Secs. Is there more room for upside?

The 2016 calendar year began with a cautious outlook on interest rates. But as the year unfolded, rates fell substantially, working in favour of debt investors. 2017 has also begun on a similar note. There are quite a few headwinds for debt market which cloud the near-term outlook on rates. But the way 2017 is different from 2016 is that a lot of positive events have already played out in favour of interest rates. Hence, in 2017, it will be a lot more difficult for rates to move down meaningfully. Markets can remain range-bound for most of 2017.

Urjit Patel revised down the target for real rates to 125 basis points from 150-200 basis points set by his predecessor. How much of a headroom does this give for a further rate cut?

In our view, policy rates heading to historical low levels is ruled out. In the best-case scenario, two more rate cuts can be expected, leading to repo rate falling by 50 basis points from hereon. The RBI paused in the latest policy because the outlook for growth and inflation, for India, is presently unclear. Our view is that growth will slow down in 2017 because of demonetisation. There will be some benefit of disinflation but that may be temporary because consumption has been deferred but not destroyed.

The RBI has set a new target of 4.5 per cent for inflation for January 2018. The new real interest rate spread is indicated at around 125 basis points. This opens up the window for a rate cut of 25-50 basis points.

This time around, we need to see if the Fed has sufficient ground to effect another three rate hikes in 2017. If this does fructify, then the two rate cuts expected from the RBI itself will be a tough task. The Fed, in our view, will indicate its path forward in the early part of 2017, and if it displays a hawkish stance, then our bond markets will be very volatile with an upward bias.

On the other hand, it is also very likely, that as in 2016, the Fed may end up doing only one rate hike.

What type of debt funds should investors go for in 2017?

While the outlook for long-term rates is unclear, we believe that there is a small window of opportunity for one to two rate cuts by the RBI, as markets stabilise and the reaction to the unexpected pause by the RBI, Fed rate hike and Trump presidency is priced in. Investors should thus not exit long-duration debt funds completely. Of their total investments in debt funds, 10-15 per cent can be in duration funds. The biggest chunk of their allocation should be in short-term income debt funds.

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