Bet on actively managed duration funds to earn high teen returns post RBI policy

The record grain production and monsoon performance has given more confidence for such projections.

We believe if core inflation surprises on the downside and settles below 4 percent RBI can reduce rates by another 25bps. On the other hand, the neutral stance will enable RBI to remain on a long pause till the time inflation remains around 4 percent mark.

Since the past few policies, we were of the opinion of the easing in policy rates sighting drop in inflation and weak growth recovery.

We also believed the drop in yield differential with developed world should be seen in conjunction with a drop in inflation differential. In fact, even after the compression in yields, the real yields in India are one of the highest supporting capital inflows. Since the start of the year, FPIs have invested Rs 1.4 trillion in the Indian bond markets.

We believe, bond markets to remain attractive in medium term for following reasons;

• Attractive real yields of 2.5-3.00 percent
• Inflation focused RBI, ensuring lower inflation outcomes in the longer-run
• Constructive outlook on INR on productivity gains and recent weakening of USD
• Continuing strengthening of Central Government position at state levels aiding reforms
• Lower inflation with low volatility will reduce inflation risk premium on INR assets

However, the journey will be with minor bumps after digesting one-time inflationary impact of HRA hikes in next 12-24 months, RBI sees the one time impact to the tune of 100bps on CPI readings.

Bond markets got what it had expected in terms of a rate cut and should welcome less hawkish commentary from the MPC.

The 10 Year bond yields should trade in the range of 6.30-6.60 percent in near term. Some volatility will be observed if state governments deficit widens to accommodate farm loan waivers and on the continuation of RBI OMO sales.

Initially, the bond curve should have a steepening bias. But if inflation settles below 4 percent, the yield curve will see some flattening in next 3-6 months.

Outlook on Bond Funds:

Bond funds have been benefitted by rate easing cycle of past year and a half generating double-digit returns. Going forward, the return expectations on the duration funds should be moderated given less room for sharp easing and lower portfolio yields.

Rates markets will be watchful of impending rate tightening cycle in the developed world, the risk of slippage of state deficit & probable OMO sales from RBI.

Nonetheless, since the inflation outlook is benign, actively managed duration funds should be able to return high teen returns for next year or so.

An important point to be considered at this juncture is that any reversal in interest rate policy may not be as steep as seen in previous rate cycle. So, at the turn of events adding to duration should be the right strategy.

Accrual & Short-term funds:

Gradual move from duration to short-term and accrual funds will make sense if yields continue to drop in future as short-term rates are attractive versus absolute government bond yields.

Disclaimer: The author is CFA, Fund Manager – Debt, Kotak Mahindra Old Mutual Life Insurance Limited. 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.