Eighteen months ago, it would have been difficult to imagine that there would be a time when debt investors in India would be spoilt for choice. But the sharp rise in market interest rates in India in the past year or so, has led to this happy situation. Between December 2020 and now, yields on a range of debt instruments – treasury bills and g-secs, commercial paper and corporate bonds, State Development Loans – have climbed 150-200 basis points.
The table above shows just how steeply yields have climbed in the last year and a half. But now that rates are on a rising trajectory, it is tempting to give in to a little bit of greed! Today, we find many investors and advisors hesitating to lock into current rates in the hope that they can earn even higher returns from their debt investments in future.
But given the difficulty of catching the top of a rate cycle (which is as tough as catching a bear market bottom in stocks), investors should not give in to this temptation. We think this is a good time for Indian bond investors to freeze on their debt strategy by locking into the good long-term rates. Waiting for the perfect time – the very top of the rate cycle - to emerge, can lead to missed opportunities which you may regret later.
PrimeInvestor was among early researchers to warn investors of the coming rise in interest rates through our debt outlook in January 2021and again in our debt outlook September 2021. We wrote about both inflation and rate risks. Having warned our subscribers quite early of the possibility of rising rates, and asked you to add short duration and floating rate instruments, we think the time is now right to lock into longer duration as well.
We see three factors that could lead to market interest rates pausing now, after their steep climb.
#1 Global commodity cool-off
One of the key factors that have propelled interest rates higher for the last six months is the narrative about persisting inflation and supply shortages across commodities, even as demand normalised post-Covid. The Russia-Ukraine conflict coming out of the blue took the entire range of commodities from crude oil and natural gas, to cooking oils and wheat to new highs in March/April this year.
But with supply chains adjusting to Russia-Ukraine disruptions and demand moderating, prices of most commodities have since cooled off significantly from their super-heated levels of March/April. The declines have been substantial, of the order of 20%-50%. Analysts in the meantime have quietly buried their forecasts about the next commodity ‘super-cycle’ and are now speculating about how long this correction may last. Though energy prices remain elevated due to short supplies, the cool off in food and feed prices is likely to show up in the inflation numbers in the coming months. This has raised hopes that inflation numbers across the world, even if they don’t collapse in a hurry, may flatten out in the coming months. The recent spike in the US Dollar Index past 108 levels is also negative for commodities, as importing nations will find it costlier to import and may cut back on their demand.
#2 Concerted cool-off
#3 Recession fears
For commodity prices to remain elevated, the global economy has to remain buoyant, industries operate at high capacity and the capex cycle shows signs of a revival. But with global central banks withdrawing liquidity at a brisk pace and incomes hit by Covid and inflation and fears of recent rate hikes hurting consumers, global growth forecasts are now being lowered sharply. US forecasters are now beginning to actively predict a technical recession (two quarters of shrinking GDP) if not a structural one. China, one of the largest global buyers of commodities, has already been slowing sharply thanks to problems of its own making. This has led global agencies like the IMF to sharply lower their growth forecasts for 2023.
Global growth in 2023 being expected at only half the levels of Covid hit 2021, doesn’t augur well for a continuation of a rising rate cycle. For one, dwindling global growth is bound to hit demand for commodities, holding back a spiral in inflation. Two, central banks too are likely to be wary of taking the unpopular step of going on raising rates when borrowers and the economy are in poor shape. This may lead to a pause in the global rate hiking cycle sometime later this year.
#4 RBI’s balancing act
In India too, after falling behind the inflation curve and hiking the repo rate sharply in the last two policy reviews, RBI seems to be preparing the ground for a pause in rates later this year. For one, India is unlikely to be immune to the global slowdown with RBI revising its growth forecasts for India down to 7.2% for FY23 from 7.8% earlier. This will force RBI to strive for a better balance between inflation control and growth stimulus in its upcoming policies. Two, RBI usually takes the view that rate hikes or cuts take 2 to 3 quarters to trickle down to the markets, in which case it may like to wait and gauge if its hike of 90 basis points in the repo rate in the last six months has managed to kill inflation. The RBI governor has hinted at this in a very recent interview. This comment saw market g-sec yields cool a bit from recent highs.
Bond investors also need to keep in mind that even if the MPC remains hawkish and decides to hike the repo rate by another 25-50 basis points in the next policy to make sure that inflation is quelled, market interest rates may not rise by the same magnitude. Bond markets like stock markets, always discount events before they unfold. Short-term interest rates in the market have run up over 200 basis points from their lows, while the repo rate has risen only 90 basis points.
All this leads us to believe that market yields may not spike up much more from current levels at this stage in the rate cycle. We think that a yield of about 7.4-7.5% on the 10 year g-sec, 7.3% on the 5 year g-sec and about 6% on 1 year T-bills represent attractive rates for investors to freeze on their debt strategies. Though there could be an upside of 25-30 basis points left, waiting indefinitely to catch rates at their absolute top can backfire in the form of missed opportunities to make the most of the attractive rates prevailing now. Yes, corporate bond spreads and deposit rates from leading banks have been slow to move with the spike in g-sec yields and have some catching up to do.
Your debt strategy
Taking the view that we may have hit an intermediate high in market interest rates, especially in g-secs, here’s how investors can approach their debt investments now. It is best to formulate your debt strategy based on the time horizon for which you are seeking to invest and the number of years you have before you need your principal back.
#1 Very short-term investment
While market yields on g-secs have run up rapidly, the interest rates on post office schemes have stayed put with the government reluctant to revise rates upwards. Similarly, systemically important banks such as SBI, ICICI Bank, HDFC Bank and other PSU banks have been very slow to react to the changing market dynamics.
We therefore think that the best parking ground for your short term need (less than a year) today lies in treasury bills (91, 182 or 364 days) or in deposits with better quality small finance banks or NBFCs that are willing to offer competitive rates to depositors. To invest in treasury bills, you need an account with the RBI Retail Direct platform. During Covid and just after it, we were worried about private banks and retail NBFCs running into troubles from Covid related retail lending and RBI’s moratorium. But numbers show that leading private banks, SFBs and high quality NBFCs have weathered this period extremely well and are now sitting on a combination of low NPAs, high capital cushions and strong liquidity, which makes their deposits a safe proposition. This has prompted us to leave out systemically important banks and introduce good quality SFBs and NBFCs into our Prime Deposit recommendations and you can pick parking grounds for your emergency money from here.
#2 Upto 3-year investment
With short term rates in the market rising quite fast, two options fit the bill for debt investments that you’d like to hold for 3 years or less. In these your options are:
- Pick NBFC deposits that we’ve recommended for 24-36 month tenures
- Or from our Prime Funds in the short-term debt category.
Investors often make the mistake of comparing the two, to conclude that deposits are the better bet. After all the FDs sport returns of 6.5-7% against trailing returns of 3-4% on short term debt funds. But this is an apples to oranges comparison because the deposit returns you’re looking at are future returns while the returns on short term debt funds are backward looking. As market interest rates rise, you can expect debt fund returns to float up sharply. The current portfolio YTMs (yield to maturities) of the short term funds in our recommended list are in the 6.7-7.2% range. Given their direct expense ratios of 0.20-0.30%, net returns in the next year or so can be expected in the 6.2-7% range, quite comparable to the FDs. The post-tax also works favourably in mutual funds, if your holding is for 3 years. For income/cash flow: If you are a Growth subscriber you can also keep a watch for our ‘high risk private bond’ recommendations too to locate high yield opportunities if you prefer some cash flow/interest pay out.
#3 4 to 7-year investment
With yields on AAA rated companies not offering enough of a risk premium over g-secs, we see two pockets of opportunity for debt investors with a holding period of 4-10 years in mind. One, they can invest in target maturity passive debt funds that invest in gilts or SDLs (State Development Loans) which offer very good risk-reward currently. We have already listed four such passive funds in this earlier article. The yields on these funds remain at very attractive levels for investment.
Do note though, that you should buy the passive MFs only if you plan to hold on to them until their target maturity date. If market interest rates rise further in the next few months, your near term returns from such funds can be low or even negative. However, given that these funds receive regular interest payouts from the bonds they own, the returns by way of income tends to make up for the short-term NAV losses from falling bond prices. Plus, the bonds will be redeemed at face value when the fund matures. Please note that if you already hold corporate bond funds from Prime Funds, you don’t need to replace them with these.
For regular income: If you seek regular income and not growth and don’t like interim NAV volatility, then participating in primary auctions of 5 year g-secs and SDLs which offer attractive yields of 7-7.5% offers a good bet too.
#4 Long-term investment
If you have been looking for good debt options for goals that are 7 plus years away or are a long way away like retirement, then this is a good time to lock into attractive rates via 10-year constant maturity gilt funds. These funds tend to own only sovereign instruments with the average maturity approximating 10 years and thus mimic the performance of the 10 year gilt in the market. This appears to be a good time to enter such funds, because the downside to bond prices from here appears limited and the fund will get to earn interest at 7.4-7.5% yield for the long term from current levels. Just like the passive funds mentioned above, these funds may deliver low or even negative returns in the short run if rates rise further. But in the long run, the high interest rates and the normalisation of the rate cycle will smooth out your returns to deliver good compounding. Check Prime Funds to choose our recommendation in constant maturity.
If you need income: If you seek regular income for the long term, and don’t like market-based volatility in your debt returns, then buying into 10 year g-sec auctions with a 10-15% allocation to SDLs from the leading States such as TN, Maharashtra, Karnataka etc would be a good proposition.