For over a year now, Primeinvestor.in has been framing its debt strategy based on the view that India’s interest rate cycle has peaked and that rates will start to decline soon.
Most bond market commentators have been waiting for the Monetary Policy Committee (MPC) rate cuts to flag off this reversal. The consensus was that the MPC was waiting for the general elections to get over to flag off rate cuts. But the review on August 8 has raised doubts about when and if the MPC will cut rates.
We think that irrespective of the timing of MPC actions, market interest rates are headed down. Therefore, debt investors need to align their bond and debt portfolios to a falling rate scenario. In this article, we offer the rationale for this view.
Hawkish MPC
In its August 8 review, the MPC kept repo rates unchanged at 6.5% with all other policy rates also staying put. Nor did it shift its stance on liquidity from “withdrawal of accommodation” to “neutral”. A shift to neutral would have signalled to markets that the MPC would consider rate cuts in its upcoming meeting. For good measure, the RBI Governor also made hawkish statements which muddied the waters on when and if a rate easing cycle would begin.
He talked of India’s growth being resilient (to read between the lines: a strong economy doesn’t need rate cuts) and pointed to CPI inflation edging up to 5.1% in June 2024. He said food inflation was persisting despite core inflation (CPI excluding food and fuel) falling sharply in May and June. He dissed the argument presented in the Economic Survey, that the MPC should ignore the volatile food component of CPI to decide on rates. RBI also increased its inflation forecasts for FY25 to 4.5%, projecting 4.4% in Q2, 4.7% in Q3 and 4.3% in Q4.
As RBI has long been saying that its ideal inflation number is 4%, this raised doubts about whether the MPC was even looking at lowering rates.
This has prompted debt investors to question if a change in strategy is necessary. If rate cuts are not in the offing, it would make sense to avoid long duration fixed deposits, bonds and debt funds and stick entirely to short-term instruments.
We don’t think such a thought is necessary. We think investors should stick to the barbell strategy we have been recommending, where they own very short term and as well as long duration debt. We had recommended this in our debt strategy article at the beginning of this year. PrimeInvestor Debt outlook for 2024.
Favourable monsoon effect
Going by history, it is best not to read too much into RBI’s inflation forecasts as they can be quite off the mark and change with incoming data. After the spike to 5.1% in June 2024, the July CPI inflation print has come in at 3.54%. But one swallow does not a summer make. A series of low inflation prints will be needed to swing the MPC. This hinges a lot on how food prices behave. Food items have been the main factor propping up the CPI in recent months. See the table below.
How food prices pan out for the rest of the year depends on the performance of the South-West monsoon. There is some good news on this front. After a dodgy start which left much of India facing deficits in June, the SW monsoon has picked up pace from mid-July. Latest IMD data shows the quantum of rainfall so far at 107% of normal with only a few pockets in North India still facing deficiencies. This has led to kharif acreage marching 4% of last year’s levels. Crops such as pulses and oilseeds, most prone to inflationary spirals, have witnessed good gains. This offers hope of moderating food prices and thus lower food inflation in the coming months.
Growth worries
While keeping a hawk eye on inflation, the MPC has often emphasised that it would also like to keep economic growth impulses alive. In FY24, India’s GDP growth gave the MPC no cause for worry, with the quarterly numbers consistently beating projections and the year closing with 8.2% growth.
The current fiscal year promises to throw up more challenges. While RBI has been optimistically expecting 7%, other forecasters including the Economic Survey expect it to turn out lower at 6.5-7%. Corporate EBIDTA and earnings trends are a good indicator to real GDP trends. But listed companies showed signs of a sharp slowdown in EBIDTA and profit growth in Q1 FY25.
Expectations of a US slowdown and geopolitical conflicts, apart from a high base effect also present challenges to growth. Signs of a GDP slowdown can prompt the MPC to hasten its rate cutting cycle.
US Fed actions
When deciding on rates, the MPC likes to emphasise that it is not guided by rate actions in the US or the Western world. But in reality, it is impossible for emerging market central banks to decouple their rate actions from the US. (In fact, it was expected Fed rate hikes that prompted MPC to begin this rate hiking cycle in 2022).
There is now a high likelihood of the US Fed starting to cut rates in its upcoming September meeting. July data on unemployment and payrolls in the US have stoked fears of a slowdown, if not a recession. The US CPI print for July showed retail inflation falling to 2.9%. The FOMC in its recent meeting has also hinted at cuts, saying it would like to strike a balance between quelling inflation and supporting growth. Calls for Fed rate cuts to avert a recession have gained ground.
Bond markets are already pricing in cuts, with the yield on the US 2-year Treasury Bill dipping from over 5.04% in April 2024 to 4.05% by August 17 2024. If the US Fed begins to trim rates from September, it would become tough for the MPC to continue holding rates. Widening rate differentials between Indian and US gilts usually prompt large dollar inflows into Indian bonds. If RBI mops up these flows to curb Rupee appreciation (which it usually does), this adds to domestic liquidity and depresses market interest rates.
FPI bond flows
In fact, market interest rates in India have already been on a declining trend, thanks to strong foreign flows.
Indian bonds were included in in the JP Morgan global emerging market bond index from June 2024. (see PrimeInvestor’s report on inclusion of India in the JP Morgan bond index) and this was expected to accelerate FPI bond inflows. As it turns out, FPIs began investing in Indian gilts well before this inclusion. After pumping in $14.2 billion in FY24, they have invested another $6 billion so far in FY25. Estimates of annual inflows of $25-30 billion from this source therefore look achievable.
Indian gilts are likely to look even more appealing to global investors after the recent Budget managed to rein in the fiscal deficit to 4.9% and indicated resolve to stick to the fiscal glidepath.
FPI inflows tend to exert downward pressure on market interest rates. This is why, despite the MPC not acting on rates, the yield on the 10-year government bond has moderated from 7.22% in April 2024 to 6.86% by August 17 2024. Short-term yields have been falling too, despite the hawkish MPC stance on liquidity.
Direction of rates matter
For debt investors, what matters is the direction of interest rates in the market and not policy actions. That means you can have a scenario of yields moving down (see table above for longer duration bonds of 3 years and above) without any MPC-driven rate cuts. Therefore, there is no change in stance in our Debt Outlook for FY24. We think investors should stick to the barbell strategy we have been recommending, where they own very short term and as well as long duration debt.
17 thoughts on “2024 Debt outlook review: Should you change your debt strategy now?”
Since interest rates have kept unchanged for long and inflation going down as expected , can an interest rate cut benefit the Debt funds having a maturity of 7-8 years?
Yes it can
Well noted and a good article. Are you envisaging any big impact of short term funds?. Coz, i will be using Floating rate fund to park bulk amount for SWP requirement and draw around 5~6%. Will there be impact in returns and whether an expectation of 6% is fair?
Floating rate funds may be a less desirable choice as rates may be at a peak. A combination of short duration funds and accrual based funds with 3 year plus duration such as corporate bond/PSU banking debt from our recommended list would give more stable income
Your perspective on long term downward trend; on the impact of bond buying by international players (after the inclusion of the Indian Sov Debt in the EM Debt index) are all aligned.
When I see the RBI gov say that we are not guided by US Fed FOMC – I would say it’s just the right choice of words. Not guided but would definitely be one of the factors. Guidance will be based on what India needs.
However I have a question on this whole thing of downward drift of the interest rates when we look at Real Interest Rates and Risk of the borrower.
While the mandate for RBI is 2 – 6% inflation, my view is at best we would land at 5% over the near long term (unlikely at 4%). If you then factor in a need for a real return of 1.0% for T-Bills, we are looking at rate of 6% for the TBills. For the longer tenure, if you add another 1.0% – 1.5% you are looking at 7.0 – 7.5%.
Even at 7 – 7.5% interest rates (for the longer dated CG Bonds), with an assumption of say 12% Capital Gain Tax – the investor would be looking at 6,15% – 6.4% after tax return – on an inflation basis of 5% (that means a Real return of 1.15% – 1.4% after tax).
For non CG debt I would think there would be appropriate markup.
So where is the opportunity for the debt (beyond Repo, and T-Bills) to go down coming from?
Are we assuming India will be able to anchor at inflation rate of 4% over extended period of time?
OR are we assuming that India will go back to periods where there’s negative rate of real returns (already the RBI Gov and FM are saying that banks are unable to attract deposits. The median age of bank deposits is about 60 years. So are we saying the government wants to short charge the senior citizens?)
I would be keen to understand and learn about the basis of our interest rates further going south across tenor.
Your points are spot on. My view is that CPI inflation will be wrestled down to 4%, due to the monsoon and through a reconstitution of the CPI basket to reduce the 45% weight in food. This is already under consideration. Though the concept of real return to savers was articulated during the Raghuram Rajan tenure, RBI has not really worried too much about assuring a real return to savers in most of its rate cutting cycles. During COVID, a terrible time for savers, the repo went down to 4.5% However this rate cutting cycle will likely be a shallow one, with maybe 100-150 bps of room to cut.
It appeared in some news papers that neutral rate has moved up as compared to past and hence rate cut by RBI may not be as much as anticipated.
Can you explain this neutral rate concept and how much rate cut one should expect?
Very short term would mean liquid funds or money market instruments only?
Neutral rate is a reference to the real return that interest rates offer over expected inflation. In theory RBI rate cuts should be a function of inflation and a real return of 1-1.5% for savers. In reality though the real return is often compromised during rate cut cycles. So we can expect a rate cut cycle but not a very deep one
For long term gains arising from Debt fund redemption for those Debt funds purchased prior to 1.4.2023, will the taxation be at 12.5% without indexation or at slab rate of the investor?
12.5% without indexation
I have well performing debt and conservative hybrid funds purchased before 1.4.2023 and I want to keep them as part of my fixed income allocation. Should I continue to hold as per my plan or should I sell those this year fearing the next or subsequent budgets might not give special status on LTCG as compared to that on new investors who bought after 1.4.2023 or those who would buy in future? Thanks
Please make decisions based on suitability, performance and risk profile. Tax should not be a deciding criteria. thanks, Vidya
Thank you for strategic perspective
Well…would you advise replacing liquid funds with Arbitrage funds or equity saving funds in view of new taxation?
Equity savings funds are not a replacement for liquid funds – they are much higher risk. Taxation alone should not be the criteria. Arbitrage funds can replace liquid to some extent, but one, short-term gains are taxed at 20% and two, with SEBI’s aims to bring down derivative trading, it may impact returns. Please read this – https://www.primeinvestor.in/reports/why-arbitrage-fund-returns-could-shrink/ thanks, Bhavana
Hi Joshi jee,
1. Your premise is a long shot. Afraid of policy changes?
2. Debt purchases before 1.4.23 are the best today & going to do very well. Wait at least two years if there’s personal need for cash. Alternatively, you will be benefited by holding on for another 3-5 yrs, say 26-28.
Regards
Thank you. Understood.