RBI has room to cut policy rates by 25 bps; here’s how to play your bond portfolio
Existing duration fund investors may continue with their current investments and not rush to exit at current juncture.
Kotak Mutual Fund
The Reserve Bank of India (RBI) in the monetary and credit policy review earlier this week slashed the repo rate by 25 basis points from 6.25 percent to 6 percent with immediate effect.
Consequently, the reverse repo rate under the LAF stands adjusted to 5.75 percent and the marginal standing facility (MSF) rate and the Bank Rate to 6.25 percent.
4 MPC members were in favour of a 25bps rate cut, one member sought a 50bps cut in policy rate and one member sought no change in policy rates.
The RBI has however maintained their neutral stance given the likely upward movement of inflation from the current levels during the second half of the year.
The RBI remains focused on its commitment to keeping headline inflation close to 4 percent on a durable basis. However, the central banker has also highlighted the fact that slowdown in growth and manufacturing activity is an issue of concern to it.
In terms of inflation, while the trajectory of CPI inflation has been lower than projected, RBI points out to the fact that there are several factors contributing to the uncertainty around the baseline inflation trajectory.
Factors such as farm loan waivers by states as well as the implementation of the state of the pay commission could have a bearing on the inflation trajectory for the second half of the year.
RBI projections now incorporate the first round impact of the implementation of the HRA (House Rent Allowance) award by the Centre under the 7th Pay Commission.
While RBI believes that banks have been able to transmit lower policy rates to new loans under the MCLR regime (marginal cost lending rate), the rate transmission for the existing loans has been slow especially under the base rate regime.
The transmission of lending rates under the MCLR regime has been faster than the base rate. RBI is looking into this matter and setting up a committee to do so.
Banks have been facing pressure on Net Interest Margins (NIMs) despite fall in the cost of funds on account of the muted trends in credit growth and the fact that incrementally banks are focusing mainly on lending to better-rated corporates.
The excess liquidity in the system is also adding to pressure on NIMs and the recent cut in savings bank rate by SBI is an outcome of the same.
Outlook and Way Forward
We believe that the next course of action on policy rates would be determined by data on inflation. In our opinion, there is room for rates to go down further by another 25bps (especially given the high real interest rates); however, the timing of the same could be data dependent.
The RBI would wait to see the impact of the fading base effect on inflation as well as the growth trajectory and then take the decision on rates. We expect CPI inflation to average 3.5-4 percent in FY18 within the medium term target of RBI at 4 percent.
Fixed income flows are seemingly dwarfed by equity flows at the current juncture domestically. However, foreign flows in fixed income continue to remain robust (around USD 22 billion in 2017).
Current allocations to fixed income could have an overweight into short term/credit accrual funds. Tail end allocations to actively managed gilt/bond funds could be considered as yields back up from current levels.
Existing duration fund investors may continue with their current investments and not rush to exit at current juncture.Disclaimer: The author is CIO (Debt) & Head – Products, Kotak Mutual Fund. The views and investment tips expressed by investment experts on moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.