The interest rate reduction cycle has only just begun

Interest rate cut cycle is already underway, has the ideal time to invest in debt funds gone by?

When the Reserve Bank of India (RBI) kept the benchmark interest repo rates firm at 8% for most of 2014, bond funds were not receiving much investor attention, despite the fact that we were sanguine on the bond market. The ideal time to invest in bond funds is when debt is not doing well.

Early into 2015, RBI surprised the market with two swift rate cuts in successive months taking the benchmark repo rate to 7.5%, and sending the bond market soaring. This drove debt funds higher and most long-tenor income funds have been exhibiting above-average performance.

Now that the interest rate cut cycle is already underway, has the ideal time to invest in debt funds passed us by? Do debt funds still have the potential to deliver returns? Yes, because there’s enough steam still left in the debt market, and investors should still get on the gravy train. Here’s why.

RBI had said that it would target a Consumer Price Index (CPI) inflation of around 6% for January 2016. Lately, the CPI inflation has been hovering at a shade above 5% on average for the past three months. The February 2015 CPI number has come in at 5.37%, which is slightly higher than January 2015’s 5.19%.

The current account deficit is around 1.6% of the gross domestic product (GDP). At $56-57 a barrel, Brent crude oil prices are now lower than last year, saving the Indian economy billions of dollars in import bills and lowering the current account deficit. In a few quarters from now, the government expects this deficit to get into a surplus zone.

When most global currencies are reeling against a stronger dollar, the rupee has been holding steady at 62.00-62.60 against the dollar. As a result of the well-behaved rupee and lower inflation, RBI had room to cut interest rates, surprisingly by a total of 50 basis points (bps), in the first quarter. (One basis point is one-hundredth of a percentage point.)

While the going is good

These are not the last of the rate cuts. There’s a high probability that RBI will cut rates further, by about another 50 bps, over the course of a year. With the macroeconomic environment just right, there is support for a downward rate cycle. Current account deficit getting into surplus territory will provide enough reason for further rate cuts.

Inflation is significantly under control at 100 bps lower than the RBI target of 6% for January 2016. Wholesale Price Index inflation is in the negative territory, coming at -2.0% for February. Last year, nobody had thought that this critical yardstick would dip into the negative territory.

The 10-year government security (G-sec)—a key benchmark to know interest rate trends in the economy—is down significantly in the past one year. The 10-year G-sec yield was closer to 9% this time last year, and is currently hovering at around 7.75%.

Time for debt to bloom

When the rates will be cut precisely is anyone’s guess, but the fact that we are heading in that direction puts debt fund investors in a sweet spot. Most use debt funds for only two of its features. One, as these funds have fixed-income securities, they form a part of income planning of an individual. Two, the debt investments provide a much-needed diversification against other riskier asset classes. But the third aspect of a bond fund is that it can provide decent appreciation, at a time when interest rates are inching lower.

If you are a newer investor into debt funds, it’s time to hurry and make most of the good environment. The 10-year benchmark could be around the 7% mark in about a year. Investors have the opportunity now because interest rates are still higher; once it starts dipping, the opportunity will slip away.

Investors have to watch out for choppiness, especially in the international economy as the dollar gains strength and the US Federal Reserve is expected to tighten its easy money policy. But this time, RBI is more prepared for a tightening in the US economy, and is likely to wait and monitor the international environment before signalling rate cuts. That should give investors enough time to invest in debt funds.

The volatility in other asset classes could also drive more investors towards debt instruments in the coming months. Investors who prefer a conservative portfolio should make use of this window of opportunity as it may not last long. Bond funds with a higher average duration are better placed in a downward rate cycle. But for those looking to diversify, a debt portfolio peppered with medium- and long-term bond funds can be a good combination as well.

This article has also been published in MINT newspaper on 2nd April 2015.

Nimesh Shah is managing director and chief executive officer, Icici Prudential Asset Management Co. Ltd.