In contrast to equities, why debt markets are still depressed?
The macroeconomic scenario has witnessed some improvement over the past few months. Ease in Inflation to acceptable levels, narrowing Current Account Deficit (CAD), and a relatively stronger and stable Indian rupee have helped change sentiments of investors.
FII Activity in Debt Markets
The political landscape ahead of the general election, indicating a possible change in Government at the center is gripping the mood of the Indian capital markets. This has led to some rally in equity markets. However a similar rally is yet missing in debt markets.
So far, high inflation and worry of Government overshooting the fiscal deficit was keeping the bond markets depressed. Likewise, concerns over liquidity were also causing yields to spike occasionally. But with all these factors turning slightly positive, it remains crucial to see the impact on long term yields and long term bond prices.
How active were FIIs in the Indian debt market?
In the months of January 2013 to May 2013, sentiments in debt markets were positive. Foreign institutional investors (FIIs) were pumping money in the Indian debt markets. And debt market investors were expecting interest rates to ease soon. But inflation continued to remain high. And the sudden exit by FIIs from Indian capital markets brought the Indian rupee under pressure and widened the CAD. As a precautionary measure RBI had to intervene to curb excess liquidity and speculation in Indian rupee.
|Source: ACE MF, PersonalFN Research
And the impact...
The impact of this was clearly seen on yields across maturities and the yield on long term instruments was impacted the most. As a result, some turbulence was caused in the Indian debt markets. The returns generated by long term debt funds fell substantially, over the last 1 year. Investors who were overexposed to longer duration funds were disappointed. Some investors even saw high volatility and depreciation in value of their debt portfolio. On the contrary, liquid funds delivered stable returns for the investors.
Lacklustre Performance of Debt Funds
|Category AverageAnnual returns: calculated on monthly rolling basis
(Source: ACE MF, PersonalFN Research)
Will the new government be under pressure to contain fiscal deficit?
The current Government has put in an ambitious number of 4.6% for this fiscal year. The government seems to apply various tactics to compress the number, without which the actual number could look uglier. Going forward, there would be more pressure on the new Government to contain fiscal deficit.
What about inflation and policy rates?
The Consumer Price Index (CPI) inflation (also known as retail inflation) rose at its slowest pace in February 2014 to 8.10%. Thanks to easing food article prices. Likewise the Wholesale Price Index (WPI) inflation (which largely captures the industrial inflation) also mellowed to 4.68%. The annual target of RBI on CPI inflation is 8% by January 2015 and 6% in the year next.
But there is an upside risk to inflation...
Unusual weather conditions in the northern and western India has raised a concern. The unseasonal rainfall along with heavy hailstorm in Maharashtra and Madhya Pradesh has affected Rabi crops badly in these states. Vegetable prices have already risen by about 10%-15%. These factors do not reflect in the inflation numbers announced for February. But the impact of these may be seen in the coming months. Also the possibility of an El-Nino phenomenon does exist this year. Prices of vegetables could further stoke up and exert upward pressure on food inflation, if a draught or deficient rainfall is indeed reported.
So before taking any call on policy rates, RBI would closely monitor inflation and assess the upside risks.
Even while the inflation is falling, the fiscal deficit has not been checked convincingly. So now the question is, will bonds stage a rally sooner or later? or would they continue to rumble under pressure? Everything depends on how RBI assesses the situation.
What should debt market investors do?
PersonalFN is of the view that RBI may adopt a wait and watch strategy. It would want inflation to sustain at below 8% levels for some more time before it lowers the policy rates. PersonalFN believes investors should stay away from all speculations revolving around talks of a rate cut. You should instead consider your time horizon before investing in debt mutual funds. Those with shorter time horizon, say less than a year, should avoid long term debt funds, as they are exposed to high interest rate risk. Moreover, on a conservative stance, you should not hold more than 20% of your debt portfolio in long term debt funds. As interest rates on short term instruments are yet high, the short term debt funds may have some edge over the long term debt funds, for now.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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