After raising the policy rate from 4 per cent in April 2022 to 6.5 per cent in February 2023, India’s monetary policy committee (MPC) decided to take a pause in its meeting last week. Though the RBI governor has warned that this pause is only for the current policy, it appears likely that we have reached a plateau, if not a peak, in this rate cycle.
Is it a peak?
There are three factors that suggest that this pause may last. One, it was a spike in CPI inflation above 7 per cent (7.7 per cent for April 2022) after the Russia-Ukraine war that prompted the MPC to flag off this series of rate hikes. But with war-related disruptions easing, CPI inflation rate has subsided below 6 per cent in recent months (5.66 per cent in March 2023).
Two, when raising rates, the MPC/RBI try to balance inflation concerns with the economy’s growth prospects. Interest rate hikes typically take 3-4 quarters to filter down to the economy and borrowers. Given that India’s GDP growth is already set to dip to 6-6.5 per cent in FY24 because of the global slowdown, the MPC may like to wait for the 250 basis points in rate hikes so far to trickle down to inflation and the economy, before considering further action.
Three, in deciding on rate policies, the MPC also takes its cues from rate actions in developed markets like the US, as their rate differentials with India impact the Rupee and capital flows. With the US Fed also expected to slow down rate hikes thanks to recession concerns and the banking crisis, there’s room for India to remain on pause.
So, if we have indeed reached a peak in this rate cycle, how should you go about choosing your debt investments? Here are three pointers.
Duration: Long over short
For Indian investors, the choice between short-term, medium-term and long-term debt instruments can be pretty confusing today, because all of them offer very similar returns. The accompanying table shows how yields on 1-year, 3-year and 5-year government and corporate bonds have almost caught up with 10-year bonds, this past year.
An investor looking to buy government bonds today may be surprised by the fact that the 10-year government bond with a 7.22 per cent yield offers just a marginally higher return than the 5-year bond with a 7.06 per cent yield and a 1-year treasury bill with 6.94 per cent. A similar situation prevails in the corporate bond market too, with AAA rated 5-year NCDs offering 7.65 per cent while 1-year NCDs offer 7.58 per cent. Given a narrow difference in yields, does it really make sense to lock into 10-year g-secs over 5-year ones, or 5-year corporate bonds over 1-year? Today it does, because of reinvestment risk.
When the market is close to the peak of a rate cycle, it is only a matter of time before rates begin to retreat from current highs. Should growth slow sharply or inflation moderate at a brisk pace, market interest rates will fall much ahead of repo rate cuts by the MPC. In such an event, yields on short-term debt instruments such as treasury bills, commercial paper, money market instruments, will be the first to react. If you invest in short-term debt options today because their rates are almost as good as long-term options, your rates could get reset lower when these instruments mature in a year or two. By investing in longer term instruments, you would be locking into higher rates for longer, shielding your portfolio from reinvestment risk.
This is why, at the peak of a rate cycle, locking into long-duration debt makes more sense than staying with short-term options. So, if investing in corporate NCDs today, longer tenors such as 5 and 7 years score over shorter ones such as 1 or 3 years. In debt funds, choose corporate bond funds or medium-duration funds with portfolio maturity of 4-5 years over money market funds or short-term funds with maturity of 1-3 years. In gilt funds, constant maturity funds that invest in 10-year gilts score over active gilt funds or short term funds with a maturity of 1-3 years. In fixed deposits and small savings schemes, you should be choosing tenures of 3-years plus as opposed to 1-2 years, to lock into favourable rates.
Credit: Quality with returns
When market interest rates are scraping rock-bottom, investors seeking better yields often have no choice but to take on credit risk (the risk of default or delay in repayments) to earn a better return. But a high-rate environment helps you enjoy high returns without having to make compromises on credit quality.
During Covid times, if debt investors wanted to earn 8 per cent plus, they had to explore riskier corporate FDs from smaller firms, NCDs rated A or lower and FDs with co-operative banks. But today, government-backed instruments such as the Senior Citizens’ Savings Scheme and NSC offer returns of 8.2 per cent and 7.7 per cent respectively. A 45-month FD from top-rated HDFC can get you to 7.75 per cent. Bonds issued by State governments offer you 7.5 per cent for 5 years and 7.7 per cent for 10 years.
While making debt allocations today, max out investments in government-backed schemes and g-secs first. If tempted to go in for riskier options such as small finance bank FDs, AA or A rated corporate NCDs or corporate FDs, don’t simply go by their absolute rates. Make sure of a material 150-200 basis points spread over government-backed options before considering an allocation.
Rates: Avoid floating for fixed
Finally, the prospect of a peak or plateau in rates also makes a case for preferring fixed rate bonds over floating rate ones, as the latter could see returns dip if market interest rates moderate from current levels. This weakens the case for GOI floating rate savings bonds, vis-à-vis a Senior Citizens’ Savings Scheme, NSC or an HDFC deposit.