What impact will high inflation and rising interest rates have on the money and debt markets? With savings bank rates deregulated, is your savings bank account an attractive option to park surplus funds? We answer these questions as we discuss the outlook for the debt market in the short and long term.

Inflation continues to remain a cause for concern for Debt Market, with the RBI raising rates again in its latest Second Quarter Monetary Policy Review in an anti-inflationary bid. However, with squeezed liquidity affecting growth rates in the country, we feel that the RBI will take a pause in rate hikes; they are also in no hurry to cut rates soon. This means that interest rates are likely to be stable for some time now, leading to flattish yield curves for fixed income products. It is thus necessary to take a fresh look at your debt market investment options and take a call accordingly.

Inflation: High but Trending Down Wholesale Price Index (WPI) inflation remained almost unchanged at 9.73% YoY in October 2011 as against 9.72% in September 2011, slightly higher than market expectations. While we are seeing peak inflation numbers at 9.7%, all subsequent readings for the next 6 to 7 months are likely to be lower because the global uncertainty may correct commodity prices. Even if that does not happen, the base effect is so strong till March-June that the numbers will start climbing lower, going forward. So, we think we are likely to see lower inflation numbers going forward.

Interest Rates: Peaked and Paused In the Second Quarter Monetary Policy Review, RBI increased the Repo Rate and Reverse Repo Rate by 25 bps to 8.50% and 7.50% respectively, in a continuation of its anti-inflationary stance. However, RBI expects WPI inflation of December 2011 to fall and has indicated “the likelihood of a rate action in December mid-quarter review is relatively low”. We also think that RBI is going to take a pause in rate hikes, because the downside risk to growth has only become more prominent in the recent past and global uncertainties continue to remain at an elevated level.

Savings Bank Rate Deregulation

RBI passed a draft order deregulating the savings bank deposit interest rate with immediate effect. The interest rate on savings deposit today stands at 4%, recently changed from 3.5%. Soon after the deregulation announcement, some private banks raised savings account interest rate to 6% per annum for balances above Rs. 1 lakh and 5.5% for deposits less than Rs. 1 lakh.

One of the biggest advantages of saving account interest rate deregulation will be that the policy rate hike will also reflect in saving accounts interest rate. A matured economy cannot afford to have such differences in the market rate and saving accounts rate. We think this is a positive move for the economy, and will increase the real deposit rates for savers, who were suffering from negative real rates.

Outlook on Debt Market:

Concerns on slippage on Fiscal Deficit and borrowing are mounting. Banking system liquidity is expected to improve marginally although it will remain in Deficit zone. We expect the 10-year benchmark G-sec to trade in a range of 8.75% to 8.90% in near term. Corporate bond yields are expected to remain range bound. Money market rates may remain range bound with upward bias due to tight liquidity conditions.

Short Term Funds

We believe that short term rates would continue to remain high as the Repo rate is likely to be maintained at 8.5% for at least 5-6 months. With the prospect of liquidity tightness in the coming months, short term cash surplus should continue to earn reasonable returns from liquid funds.

One year from now in our view, rates cannot remain at the elevated levels where we are now. So at the end of one year, if rates come down significantly, the re-investment would be made at a lower rate. This can be avoided if one gets into short term bond funds, where because of the current flat yield curve the portfolio yields are quite high.

Long Term Funds

The outlook on rates one year down the line seems to be quite positive. So once interest rates start falling, medium to long-term debt funds are bound to do well. We think the time is right to add duration to portfolio for investors who have a horizon of more than two to three years.
In long term view, there are two product categories which can be considered, which are different as far as risk-reward profile is concerned: Income Fund and Dynamic Fund.

• The Income Funds carry relatively less risk than the Dynamic Fund category. Investors with a reasonable risk appetite can expect decent returns from Income Funds over 1-2 years.  Income funds have delivered decent returns last year. Average Category Return of Income Funds was 6.92% per annum.
• A Dynamic Fund is perhaps more suited to an investor with a greater degree of risk appetite, as the argument for Dynamic Funds assumes that the fund manager would be able to exploit each and every rate move perfectly. In practice to do that is not an easy task. Returns from Dynamic Funds since last year were much better than returns from Income Fund. Average Category Return of Dynamic Funds was 8.49% per annum.

Conclusion

All indicators seem to point towards a lower-inflation, stable interest rate scenario. However, inflation remains the key risk to be watched for the fixed income market. Globally if the sovereign debt crisis situation in Euro Area appears to be getting close to a resolution, and commodity prices start moving up again, then inflation becomes a worry. In such a scenario, the chances of RBI pausing rate hikes would reduce. That is a risk that we need to watch out for.