Key Points:
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RBI has indicated a shift in policy from anti-inflation to growth
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Inflation in India has come down due to high base effect
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RBI may start rate cuts in 1Q FY2013 (or 2Q 2012 in calendar year terms)
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Investors should start investing in Long Term Debt Funds as falling interest rates will benefit the long-term bonds.
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Dynamic Bond Funds may deliver better risk-adjusted returns
RBI stops after 13 rate hikes
After 13 consecutive rate hikes, the Reserve Bank of India (RBI) has decided to bring monetary tightening to a temporary halt in December 2011 as inflation has finally started to show signs of easing. The RBI has kept the key policy rates unchanged in its Third-Quarter Monetary Policy Review, which was held on 24 January 2012. The central bank has cut the Cash Reserve Ratio (CRR) by 50 basis points to 5.50%, which will ease liquidity conditions in the banking system by injecting Rs. 32,000 crores. The RBI has also cut the GDP growth forecast from 7.60% to 7% for the FY12. However it kept inflation projection unchanged at 7%. After reaching a high of 10%, year-on-year in September 2011, the Wholesale Price Index (WPI) fell for 3 consecutive months to 7.47%, year-on-year in December 2011.
With low pressure on commodity prices, high base effect on wholesale prices and high borrowing costs which has curbed the investment and consumption, we are of the view that inflation is more likely to trend further down. In addition, RBI has indicated its intention to shift policies towards pro-growth, hinting that interest rates are more likely to be lowered in 2012. Currently, RBI’s repo rate stands at 8.50%, the highest since February 2001, leaving the central bank plenty of room for cutting interest rates. While we do not expect rate cuts to take place yet, we believe that such a move is likely to materialise as early as 1Q FY2013 (or 2Q 2012 in calendar year terms).
What does this mean for investors?
Bond prices, which have an inverse relationship to bond yields, should appreciate when interest rates fall. Furthermore, longer dated bonds should see bond prices reacting in larger magnitude due to their higher sensitivity to interest rate changes (longer dated bonds have longer duration, a measurement of bond price sensitivity to interest rate changes). With expectations for both inflation and interest rates to trend lower in 2012, investors should benefit by investing in longer-term debt funds which have the portfolio of long dated bonds.
Recent testament – impact of falling rates on long term debt funds
In fact, the CRISIL Composite Bond Fund Index has recently delivered good returns of about 2.83% in the last 3 months starting from November 1 2011 to January 30 2012. The move was justified by falling inflation expectations as the WPI recorded 3 consecutive months of easing inflation. It fell drastically from near about 10% in September 2011 to 7.47% in the month of December 2011, and we saw positive returns in long-term debt funds.
Long Term Debt Funds and Dynamic Bond Funds looking attractive for Investors
In view of our expectations of falling interest rates and inflation, we believe that current market conditions are favorable for long-term debt funds, once the rate cut cycle begins (again, our expectation is for rates to cut as early as 1Q FY2013 or 2Q 2012 in calendar year terms). Hence, for investors who have a horizon of more than 2 years, and do not mind possible near term volatility, we believe now is a good time to start accumulating long-term debt funds as part of one’s portfolio.
Also, we believe that Dynamic Bond Funds are attractive as they may deliver better risk-adjusted returns given their flexible mandate. These funds have the flexibility to invest across money market, gilts and also corporate bonds. Apart from the flexibility of changing allocations within the debt categories, the dynamic bond funds also have the mandate of aggressively altering the portfolio duration in response to the evolving market dynamics. Dynamic Bond Funds are better positioned to face expected headwinds in the form of fiscal pressures and external events. We recommend investors who have investment horizon of 1-2 years to look for Dynamic Bond funds considering the expected volatility in yields.
Table 1 – Funds we recommend for this asset category
Fund Brief
ICICI PRUDENTIAL INCOME PLAN
ICICI Prudential Income Plan is an open-ended debt fund. This fund is suitable for those investors who seek to deploy part of their funds in fixed income products as a conscious investment option. It enables the investors to earn a total return made up of both interest income, and changes in the value of capital; a facility that comes only with debt funds that do not restrict themselves to generating merely interest income. As market interest rates change, the value of your portfolio also changes, creating a total return portfolio in debt securities.
This fund is basically for -
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Investors seeking exposure to long-term debt markets
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Investors aiming to earn total return rather than interest income alone
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Investors wanting to create a portfolio of debt securities over the long term
The fund has most of its portfolio in long dated bonds. The fund's AUM was Rs. 251 crores as at December 31 2011. The fund has been a consistent performer and has generated CAGR return of 8.66% in last one year and 9.18% over last 5 years (as at January 27, 2012).
BIRLA SUN LIFE DYNAMIC BOND FUND
Birla Sun Life Dynamic Bond Fund is a dynamic income solution that aims to generate returns with active management in bonds of quality companies to capture positive price movements and minimize the impact of adverse price movements.
This fund is basically for -
The fund has the most of its portfolio in AAA rated securities. The fund’s AUM as at December 31, 2011 was Rs. 3593 crores. The fund has been a consistent performer and has generated CAGR return of 8.95% in last one year and 6.94% over last 3 years (as on January 27, 2012).
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