Most bond market participants believe that we are at the end of rate cuts? What is your view?
We are indeed getting closer to end of rate cut cycle. Interest rates are reduced so as to ease the dual problems of cost of money as well as availability of money so as to sustain growth momentum.
Cost of money has been addressed by cutting repo rates and infusing a high amount of liquidity. As this high amount of liquidity sustains in the system it will eventually address the problem of availability of money thereby fuelling growth momentum.
Hence from a view perspective, the rate-cut cycle is closer to the end. That said, liquidity surplus is likely to persist so as to ensure cheaper cost of money percolates in the broader economy so as to sustain growth revival.
Are we going to witness a long pause, considering there are still many uncertainties and easy money conditions prevailing across the globe?
While the remedies (vaccines) may appear within sight, the journey towards the destination still remains a roller-coaster. Till then, easier money conditions are unlikely to translate into sustained demand, thereby forcing the central banks to maintain easy liquidity conditions with a longish pause.
When do you see RBI start raising the rates?
For the extent of ammunition used by central banks, including conventional and unconventional measures, we expect a high rate of conviction on growth reversal before we see any prospects of withdrawal of liquidity. As things stand, when we see green shoots in the economy on one side and certain parts of the globe initiating further lockdowns; it certainly looks early enough to factor this risk playing out immediately.
For rates to rise, the stance of monetary policy has to move away from accommodative and excess liquidity needs to reduce.
These aspects can change when fiscal-fed growth sustains upside risks to inflation, forcing RBI to move away from accommodative stance and withdraw liquidity. In this context, fiscal push is restrained, and it is too early to conclude that supply-driven inflation will sustain.
Hence, until the demand shows signs of sustenance amidst low interest rates, we expect rates to remain on status quo.
Anecdotally, the interest rate cycle has turned when the yield curve is relatively flat. Currently, the yield curve is very steep reducing the prospects of immediate reversal in the rate cycle.
How can debt mutual fund investors safeguard their investment in such a scenario?
Returns in fixed income are driven by accruals and capital gains. Considering the present yields on short term assets; accruals are considerably low and prospects of capital gains remain thin. Medium to long end yields are providing both accruals as well as prospects of capital gains (as we expect the yield curve to flatten.)
In order to withstand volatility in the medium-long-end bonds, investors can opt to apportion investments between short tenor roll down funds and open ended funds bearing flexibility to operate at higher duration.
With the expectation for the yield curve to flatten from current levels, open-ended funds operating at higher duration can benefit through higher accruals as well as prospects of capital gains whilst the roll down funds bearing shorter tenor will reset on their own and align with rising rates. Apportioning between these two funds / strategies will reduce the duration profile of the investments, thereby aiding to reduce overall volatility.
Even when the RBI was cutting rates, the usual cheer was missing in the bond market. The standard advice given to investors was to stick to short term debt funds. Will the same strategy work even as rates like to stay in a tight-range or start moving up? What is your advice to debt mutual fund investors?
If the ‘cheer’ resorts to instant gratification of a view materialising; then indeed there was a miss. That said, such rate cycles have a very short shelf life, often leaving the investors with opportunity losses or notional gains. Withstanding a larger rate cycle in either direction will give ample occasions to cheer across both segments of the yield curve (sovereign and credit) within the fixed income asset class.
To see through an interest rate cycle and optimise for a favourable risk reward; we propose to identify strategies in line with the shape of the yield curve.
Interest rates play out in three phases. In phase one, when the yield curve is flat at elevated yields, the duration segment is expected to outperform. Yield curve tends to steepen in phase two wherein medium to long tenor bonds provide a favourable risk reward opportunity. Lastly, in phase three when the yield curve flattens at lower yields; credit and one year roll down funds tend to outperform.
Rate cycles tend to play out in above phases and in the following order. We call this FIRE strategy – Find Invest Ride & Exit strategy – for fixed income investments. Investors can choose the strategies based on the shape of the yield curve and their horizon of investments.
The above narrative has been our ‘standard advice’ at all times!!
Many investors have recently started investing in medium duration funds. What are the prospects of these schemes? Who should invest in them?
Going by the above, through the current phase (phase two) of interest rate cycle when the yield curve is very steep, medium to long end bonds provide a favourable risk-reward, owing to steepness in the yield curve. Softening rate cycle tends to end with the flattening of the yield curve at lower yields, providing prospects of returns from accruals as well as capital gains. Important to remember to press the exit when the yield curve flattens at lower yields!!
Is it time to get out of long duration and gilt schemes?
Firstly, to differentiate gilt and a long duration scheme; Government Securities Fund or a gilt fund bears the flexibility to operate across duration profiles. Based on the shape of the yield curve and the view of the respective fund manager this fund can reflect a duration profile of ultra-short term fund or a short term fund or operate at higher duration confining to investments in government securities. Long duration funds bear a minimum floor of duration to be maintained at all times.
When long-tenor yields rise, long duration funds can bear an adverse impact as these funds can’t reduce duration beyond a certain threshold. On the other hand, gilt funds bear the ability to lower their duration considerably in times of rising rate scenario.
Hence, in lines with the view mentioned above, as the yield curve flattens one can exit from the long duration fund. The gilt fund investor can expect the fund manager to reduce duration as the yield curve flattens and hence need not merit any action. In other words, Government Securities Fund (Gilt Fund) can also operate as an all season fund bearing exposure to the government securities.