While expensive valuations of Indian equity markets is a hot topic of discussion among savvy investors these days, what goes completely unnoticed is the unprecedented rally in Indian bond markets. The yield on India's 10-year 7.59% 2026 G-Sec yield has fallen nearly 82 bps (basis points) over the last 7 months -- a steep decline considering that RBI has cut policy rates just by 25 bps since the beginning of this calendar year. Bond yields and interest rates share an inverse correlation with bond prices.
 

Yield softened…and rather fast!

Data as on September 16, 2016
(Source: Investing.com, PersonalFN Research)
This led to a rally in the bond market – especially at the longer end of the yield curve -- primarily driven by the expectation on moderation in inflation on the back of prediction of good monsoon. An equally major contributing factor was easy liquidity conditions. And even now, RBI (as per the third bi-monthly monetary statement for 2016-17) has decided to infuse durable liquidity in the banking system to neutralised the liquidity position. This is aimed at improving the monetary policy transmission in the economy.

The rally was further supported by protracted, flat, and/or negative bond yields in developed countries. Between April and June, the U.S. 10-year sovereign bond yield fell from 1.72% to 1.38%, while the 10-year Germen sovereign bond and Japanese bond yield, during the same period, entered the negative terrain. And these factors made India bonds more attractive to the global investors.

But now the question is, will this trend continue in the future?

Well, it seems unlikely. Domestic as well as the global factors that triggered the sharp fall in bond yields might reverse, or become less relevant in the foreseeable future.

Simply put, the rally that we've witnessed so far in the bond prices that translated into smart gains for debt fund investors, is likely to run out of steam. This is because…
 

• Going forward, inflation may not soften much: As you are aware, inflation measured by the movement of the Consumer Price Index (CPI) stood at 5.05% in August 2016. A sharp fall in vegetable prices and some moderation in prices for pulses aided the overall decline in the retail inflation. Although there's no foreseeable upside, threat to food price inflation (thanks to satisfactory monsoon and adequate water storage in India's 91 major reservoirs), prices in many categories such as sugar and confectionery products, animal proteins, etc. have remained firm. Moreover, the implementation of the One Rank One Pension (OROP) scheme and 7th pay commission may add to inflationary pressures. While existing utilised capacities in the manufacturing sectors will help to absorb a part of incremental demand, the increased consumption demand is likely to create upward pressure on inflation.
  
  Expectations of households on inflation, which is one of the most crucial factors and taken into account by RBI when deciding on the direction of monetary policy; have gone up sharply in the recent times. As revealed by the 44th round of survey conducted by RBI in June 2016 (reported in August), the median of 3-month and 1-year inflation expectations stood at 9.2% and 9.6% respectively — way above current inflation numbers.


• RBI has limited room for cutting policy rates: As the downside in retail inflation appears limited, the scope for a further rate cut is expected to diminish going ahead. Moreover, the reluctance of banks in passing on the benefits of rate cuts to the borrowers would be another reason why RBI might hold rates unchanged until banks take corrective measures. The central bank is committed to achieving the inflation target of 5% by March 2017. Furthermore, the Government and the Central Bank have agreed to contain inflation to 4% over the interim and long term with a 2% margin of error on either sides. Under such circumstances, RBI may prefer to take its time on rate cuts.


• Constraints on a liquidity-driven rally in bonds: A few months ago, when the RBI started its effort to infuse durable liquidity in the system, there was a liquidity deficit. As against that, we now have a liquidity surplus. Therefore, the dose of a liquidity injection might be a bit slow-release, putting pressure on the liquidity-driven rally to bond prices.


• The bond yields in the developed markets have started going up: As the consensus on U.S. hiking policy rates sooner or later begins to build up, the Treasury yields in the U.S. have started inching northwards. Similarly, German bund yields after falling in the negative territory for a brief time, have bounced back in positive. Likewise, Japanese sovereign bond yields have also recovered from their lows and await the policy response from the Bank of Japan (BoJ).
  
  Although, the bonds yields in India may not show the corresponding movement of equal or greater magnitude due to favourable domestic factors, catching a similar trend can't be ruled out.

 

So, should you expect a sharp move in the bond yields?
There is a very remote possibility of a sharp movement considering robust fundamental factors that primarily drive debt markets.

As we might be nearing the end of the ongoing interest rate cycle, how fiscal and current account deficit data comes in is extremely crucial, besides inflation. While the budget deficit indicates the health of the Government's balance sheet and the fiscal discipline, the current account deficit indicates the potential strength of Indian Rupee. Both these factors collectively decide the attractiveness of Indian debt to the global investors.
 

• Progress on fiscal deficit
  The Government has set a target of containing the fiscal deficit to 3.5% in FY 2016-17. Although the deficit has reached a level of 73.7% in the first four months of FY 2016-17, the situation is expected to improve going forward. The primary factor for high fiscal deficit has been the frontloading of a majority of Government expenses. As against that, the revenue remained muted in the first quarter of FY 2016-17, which is not unusual.
  
  As reported by the Department of Revenue, direct tax collections have improved by 15.03% between April 2016 and August 2016 as compared to those reported during the corresponding period in the last fiscal. Direct tax collections as on August 31, 2016, stood at 22.30% of the full year budget estimates. Indirect tax collection at 43.2% of the full year budget forecasts by the end of August 2016 was more robust in comparison to the direct tax collections.
  
  However, the situation is likely to improve in the future. A part of the money that the Government will spend on the implementation of 7th pay commission is likely to return in the form of taxes. As the consumption picks up and economic activity revives further, tax collection is likely to improve. As far as collections in the personal Income-tax goes, the Government is likely to be aggressive and instill a crackdown on the black money once the window period given to hoarders end on September 30, 2016. The Government has also been running a Tax Dispute Resolution Scheme to reduce the tax litigations and garner more revenue.
  
  Moreover, the fiscal deficit number may look less threatening in the next quarter, when the effect of the dividend paid by RBI will get reflected in the Government's balance sheet. The RBI has paid a dividend of whopping Rs 65,875 crore for FY 2015-16.


• Narrowing Current Account Deficit (CAD)
  Besides the fact the current account deficit has narrowed, there are expectations that it'll turn to surplus in Q1FY17. The Citigroup aired its optimism in a research note saying, "Following a moderate current account deficit of USD 0.4 billion or (-) 0.1 per cent of GDP in January-March quarter, we expect current account to come in at a surplus of USD 2 billion or 0.4 per cent of GDP in April-June quarter."
  
  Strong Rupee, higher real interest rates in India and better performance of current account would lessen the impact of the hardening of yields in developed economies on Indian bond markets.

 

Will Federal Reserve in the US hike interest rates?
Well, it looks unlikely the Federal Reserve (Fed) would hike interest rates in a hurry. Thus in the impending FOMC meet, interest rates are likely to stay unchanged.

However, the guidance may become more consistent with the previous remarks of the Fed; wherein the committee had spelt out "inevitability" of the potential hike in the interest rates. While we are likely to get greater clarity in the meeting scheduled for September 20-21, there is a possibility that the changes would be more gradual than what the markets have factored in for. End of near-zero interest rate regime in other developed countries also appears unlikely, given the fragility of economic growth in some of them.

How should investors read this?
The majority of the rally in Indian bonds might have already happened, and if we are near the end of the current credit cycle indeed, the long-term bond funds are unlikely to generate returns as they have over last couple of years. Within long-term debt funds, accrual funds, which follow the buy and hold strategy might outperform others. The shorter end of the maturity curve will be more guided by the liquidity and thus likely to remain unattractive as well. Any sudden jump in the fiscal deficit may be the biggest challenge for bond markets going forward.

On the backdrop of the above conditions, look at your time horizon before investing in any debt fund. Therefore, don't go overboard while investing at the longer end; refrain from investing more than 20% of your allocation in debt funds.

PersonalFN suggests, consider dynamic bond funds (as they are enabled by their investment mandate to take positions across maturity profile of debt papers) while taking exposure at the longer end, provided you have an investment horizon of at least 3 years.

In case you have a time horizon of less than a year, stay away from funds with longer maturities. If you have a short-term investment horizon of 3 to 6 months, you could consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extremely short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds. Don't forget that investing in debt funds is not risk-free. Therefore consider the 5-facets while investing in debt funds

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