Over the past few months, the interest rate cycle in India has turned a corner.
The Reserve Bank of India (RBI), having prioritized growth earlier to mitigate the adverse impact of the COVID-19 pandemic, recently hiked policy rates and taken other measures to control persistently high inflation. The RBI has raised the policy rate (repo rate) four times this year by a cumulative 190 bps: May (4.40%), June (4.90%), August (5.4%) and September (5.9%).
RBI’s measures have resulted in rates at the shorter end of the yield curve moving up sharply (250 bps) on the back of a sharp decline in banking system liquidity amid improved credit offtake, forex intervention and the liquidity absorption measures conducted by the central bank.
Going ahead, given the slowdown expected globally as central banks tighten rates and prospects of a sound Rabi crop, inflation is expected to come off towards the end of the current fiscal. This could potentially mitigate any further upward pressure on interest rates due to higher imported inflation amid a stronger dollar and persistent supply-chain disruptions.
Chief Economist at Axis Bank, Saugata Bhattacharya, believes that the RBI would likely go to about 6.25% at least in this cycle. However, that will be dependent on the data prints. “Till now, central banks have been front-loading their rates, irrespective of where inflation growth is. In India, we are beginning to reach a point where it's now likely to be more data-dependent going forward,” he said at the recent Morningstar Investment Conference. Read his detailed views in How do we increase Per Capita GDP?
Pranjul Bhandari, Chief India Economist at HSBC Securities & Capital Markets (India), too believes that the rate hiking cycle is not over. “The RBI spoke about real neutral rates of 1% recently. If you have a one-year ahead inflation forecast of say, 5.25%, then the repo rate should go to 6.25%. Will that be good enough to bring inflation down to the 4% target? I don't think so,” she explained at the conference. Read her detailed views in A frank assessment of the Indian Economy.
So how should investors be positioned?
With the yield curve now flattening meaningfully from the year-ago levels, the incremental reward for risk (added yield for investing in higher duration) has diminished meaningfully. This has lowered the attractiveness of investing in higher-duration securities.
From a credit perspective, the corporate bond spreads are still tighter (lower) compared to their long-term average implying mark-to-market risk to investors when spreads subsequently widen. Hence, investing in shorter-duration G-secs appears to be a better bet at the current juncture.
Those investing with a fixed horizon in perspective, can consider Target Maturity Gilt funds (much safer given the sovereign guarantee) having a maturity date close to your investment horizon. These entail minimal interest rate risk if held to maturity and also have a low expense.
Investors with a reasonably long horizon of more than 3 years could look to follow a Core-and-Satellite approach.
Core Allocation
- 70-80%: This can be the allocation of the fixed-income portion of the portfolio
Of which:
- 10-20%: Money market funds (liquid, ultra-short)
- 60-70%: Shorter duration high credit quality accrual funds (low duration, short-duration, medium duration, floating-rate funds)
Satellite Allocation
- 20-30%: This can be the allocation of the fixed-income portion of the portfolio
This could be spread across
- Medium-to-long term duration funds
- Dynamic Bond Funds and Credit Risk funds, with the exposure being tilted based on opportunities across the yield curve.
A word of caution
The recent spike in volatility in equity and bond markets can be unnerving. Remember markets are cyclical by nature and periods of strong performance would tend to be followed by periods of under or low performance.
As an investor, you need to focus on your goals, stick to your asset allocation plan, and avoid making decisions driven by short-term trends.
Please do read R Sivakumar's advice for the debt investor.