Monetary policy of RBI always has some surprise element attached to it. Sometimes RBI increases the policy rates, contrary to expectations. While on a few occasions, it gives relief by taking softer stance. On June 03, 2014, RBI announced its second bi-monthly monetary policy review which had no surprise. RBI kept policy rates unchanged, as expected. Yet the yield on 10-Year sovereign bond dropped to 4-month low. About a month ago, 10-year G-sec yield had breached 9.0% mark but now has fallen to sub 8.6% levels. Not only that, in May 2014 10-Year sovereign bond posted biggest monthly rally in the last 1 year. While the bond yields and interest rates in the economy move in the same direction, the bond Prices and bond yields move in opposite direction. Sentiment is turning positive for long term debt instruments. While long term debt funds have disappointed investors so far, it seems they might be turning around. Are they really? Let’s assess…

There are certain positives due to which bond yields have fallen
 

• Stable Government at the centre
• Rupee appreciation
• Growth in forex reserves
• Falling Current Account Deficit (CAD)
• No further rise in fiscal deficit over revised estimates for 2013-14
   

But there are some negatives as well….
 

• Possibility of lower rainfall this year
• Possibility of higher inflation
• Constraints on lowering fiscal deficits and subdued growth
• Threat of U.S. treasuries turning more attractive, if the U.S. starts hiking rates
   

Indian economy has been growing at sub-5% level for 2 consecutive years now. Manufacturing growth has remained extremely poor. PersonalFN believes, although inflation management remains the prime focus of RBI, it will have to do a balancing act between growth and inflation. In this policy review RBI has not raised rates despite there being upside threats to inflation. Thus, it is expected that, now even the Government will have to strike a balance between pushing growth and managing welfare programmes. Under UPA II regime, the Government spent a good deal of money on sponsoring welfare schemes. But it failed to raise revenues, especially the tax receipts. As a result, fiscal condition constantly remained under pressure and deficits high. But expectations are high that, situation would improve under NDA rule. Finance Minister Mr Arun Jaitley has been talking tough on fiscal management. He also has hinted that the actions of the Government would be well co-ordinated with those of RBI. Such comments have been a sentiment booster.

What to expect

The Modi government has planned a 2+3 formula. It plans to focus on repairing the economy in the first two years and then aggressively push for growth in the remaining three years of its term. First budget of the NDA Government is expected to be rolled out in the first week of July 2014. Emphasis on fiscal management and deficit control would be positives. It is also expected that, NDA may introduce some tax reforms as well. Further, what steps the Government takes to promote growth would be watched closely. Rationalisation of subsidies and rationalisation of other expenditure may send positive signals.

PersonalFN is of the view that, debt funds with longer maturities may start performing if interest rates were to ease. Long term bonds may get back in demand if inflation and fiscal deficits are contained and economic growth doesn’t slip further. But do not forget, constantly rising diesel prices and below normal rainfall may be a hurdle in containing inflation. On the other hand, liquidity in the system may ease or at least may not harden further. This may consolidate yields on short term bonds with a slight downward push. Those with 2-3 years of time horizon may take some exposure in debt funds having medium to longer maturities. But we do not recommend aggressive buying in longer maturity funds. Moreover, cautious and staggered approach should be adopted while buying in such funds. Economy is still fragile and external risks also can’t be ruled out.

Having said this, PersonalFN believes, before you invest in debt funds you must know your risk appetite and time horizon for which you can stay invested. Long term debt funds can be as volatile as equity assets. But things may be turning positive for long term debt funds after many quarters of wait. Yield curve has to normalise, if Indian economy is to get back on track.

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