Debt funds: Are the yields attractive enough to buy?

Rising equities ignite interest in private credit funds: Jhalaria of InCred Investments

Expectations of a below-average monsoon, rising vegetable prices, and firm crude oil prices made many think that inflation would make a strong comeback around the time of the monetary policy announcement in August.

However, inflation for August actually eased to 6.83 percent from a 15-month high of 7.44 percent in the previous month. Bond yields also came down slightly. Does that mean the upside in bond yields is over and this is a good time to allocate money to debt funds?

Inflation

Sticky inflation has been a cause of worry for many central bankers around the world who vowed to rein in price rises by hiking interest rates. Though the interest rate hikes have slowed, the tough talk on inflation continues.

The Reserve Bank of India increased its inflation projection to 5.4 percent for FY24 in the August monetary policy committee review from 5.1 percent earlier. Though inflation in recent months had been higher than the 6 percent upper limit set by the RBI, experts said price rises may not cross that level again soon.

Suman Chowdhury, chief economist and head of research at Acuite Ratings and Research, said, “With the moderation in vegetable prices, headline CPI inflation has quickly moderated by 60 bps in August. This is a relief to the central bank and reflects the steps being taken by the government to cool down food prices.”

He expects food inflation pressures to recede as kharif output starts coming into the market and administrative interventions by the government accelerate to curb price pressures for select food items. This should help push headline inflation below the upper tolerance threshold (of 6 percent) from the third quarter of FY24, even though it is likely to overshoot the estimate by 40 bps in Q2. He maintains an inflation estimate of 5.6 percent in FY24 CPI.

Interest rates

Put simply, inflation is not going to go up materially. If government intervention works and prices stabilise, then earlier expectations of an end to interest rate hikes may still hold good. However, rate cuts may take time.

“Investors should not expect a major shift in interest rates in the near future. The information flow in the coming months should decide any change in stance by the RBI,” said Vikram Dalal, founder of Synergee Capital Services.

Bond yields are responding to the information flow. After hitting a recent high of 7.25 percent, the 10-year benchmark bond yield dropped to 7.15 percent, after hitting a low of 7.1 percent.

“Expectations of the inclusion of Indian government securities in the global indices have been bullish for bonds. This has caused a fall in bond yields as more money will come in if the index inclusion goes through. If the index inclusion does not happen, the yields will inch up marginally,” said Joydeep Sen, a Mumbai-based corporate trainer (financial markets). On September 21, JP Morgan included Indian bonds in its emerging-market index. This, experts like Sen, say is expected to attract significant foreign investments, A Moneycontrol report points out that Indian bonds will make up a maximum of 10% in the index, with HSBC estimating potential flows of up to $30 billion. Expectations of more foreign money coming into the debt market through government securities may bring down bond yields.

“Resolution of the tiff between the RBI and European market regulators over the audit of some market infrastructure institutions, along with other operational issues and the inclusion of Indian government securities in the global debt indices can pave the way for large capital inflows in the Indian debt markets, thereby pushing down bond yields,” said Dalal.

If money flows into government securities, the 10-year benchmark bond yield may drift lower to 6.85 percent-6.75 percent over the next six months.

What should you do?

While inflation needs to be watched, money flows cannot be ignored. Investors may get to participate in the rally in the bond markets, especially if the US Federal Reserve announces the end of the rate hike cycle.

On September 20, the Fed held interest rates steady but left the door open for a further rate increase by the end of the year. Though there is no immediate sign of a rate cut, patient investors can make money in good quality bonds.

“Spreads between corporate and government securities are reasonable, as against the very low level a year ago. Also, the interest rate hikes by the RBI seem to be over. Hence, this can be a good time to look at target maturity funds matching your time frames. Corporate bond funds, banking and PSU debt funds are also attractive. Ideally, investors should match their holding timeframe with the duration of the debt fund,” said Sen.

The yield to maturity of corporate bond funds and banking and PSU debt funds stands at 7.52 percent and 7.5 percent, respectively, on average, as per Value Research on August 31. Even if one considers an expense ratio of 50 basis points, the expected returns of about 7 percent are attractive.

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If inflation goes up due to a further spike in crude oil prices and the central banks hike interest rates, then these funds may show some mark-to-market losses for a short while.

Hence, only patient investors should look at investing in well-managed debt funds. Though capital gains on units of debt funds acquired after April 1 are taxed at the individual’s slab rate, they are taxed only when the investor books a profit. This makes debt funds an attractive vehicle to postpone the tax liability of investors.