Government securities may yet see prices dip, as their
supply over the next few months is expected to be high. Corporate bonds,
especially those from top-rated companies, may deliver better gains.
For most of 2011, interest rates were on the rise, whetting
the appetite of investors for debt investments. With rate cuts expected after
March, what's the outlook for the bond market?
Interest rate outlook
The RBI has clearly indicated that it will stop raising interest
rates. So markets are now betting on policy rates coming down. The recent
moderation in inflation and slowing economic growth have supported this view.
The markets are expecting the RBI to cut repo rates by 50 to
75 basis points over the next 12 months. The cuts are expected to begin after
July but we think the cuts may not be as steep as in 2008-09 when rates fell by
4.25 percentage points over six months.
This is because India's troubles with inflation, the key
metric that the apex bank is watching, may not yet be over.
First, although food and primary inflation have abated
recently, manufacturing inflation has not. Pending increases in coal prices and
electricity tariffs may also feed into manufacturing inflation.
Second, though global commodity prices have cooled off
recently, rupee weakness has offset much of this correction for Indian
importers.
Third, crude oil prices, a key inflation driver, have not
corrected by much. Any oil price hikes post-election may further fuel
inflation.
Time not right for gilts
Based on the expectation of rate cuts, benchmark 10-year
gilt yields that hit a high of 9 per cent in November have cooled to 8.26 per
cent now. But this may not be an opportune time to enter gilts for two reasons.
One, the supply of gilts is likely to rise over the next
three months owing to a slippage in the fiscal deficit targets. This may
pressure gilt prices and push up yields.
Debt markets early in 2011 cheered the lower borrowings
announced by the government. But a fall in small saving inflows and lower
disinvestment income has already led to government hiking its borrowing target
by close to Rs 92,872 crore for this fiscal (a good 22 per cent more than the
budgeted market borrowings).
Two, banks are today heavily invested in government bonds as
the credit off-take continues to be subdued. If demand for credit increases in
coming months, banks may reduce gilt investments, also pressuring prices.
These factors suggest that this may not be a good entry
point into long-term gilts.
The only liquid avenue available for retail investors
interested in government securities is through gilt mutual funds.
Returns on these have been quite volatile. Ten-year gilt
yields have swung from 5.2 to 9.4 per cent in the last five years. In addition,
because of their longer-term investments, these funds register higher capital
gains or losses on their NAV based on whether interest rates fall or rise. The
average returns on gilt funds over the last five years have been 6.6 per cent.
Timing your entry well is quite important while investing in gilt funds.
Investors seeking safety, however, can instead get exposure
to top-rated quasi government entities through some ongoing bond issues. For
instance, upcoming tax free bonds of Indian Railway Finance Corporation, HUDCO
and infrastructure bonds of REC, PFC and IDFC can be considered.
Interest rates on such bonds are linked to government
security yields. Interest rates of close to 8 per cent for tax-free bonds are
attractive for investors in the high-tax bracket.
Corporate debt better
While long-term gilts don't appear attractive now, bonds
from top-rated corporates do. From here, top-rated corporate bonds may
outperform gilts for two reasons.
One, as Ritesh Jain, Head of Fixed-Income at Canara Robeco
says, the balance sheets of top-rated corporates are in much better shape than
the government. While the government is on a borrowing spree, top Indian
companies have been cutting back on their investment plans, reducing debt on
their balance sheets and hoarding cash.
Any issuances by them are, therefore, likely to be quickly
picked up by institutional buyers.
Two, thanks to the same cautious mood, the supply of paper
from them is also not likely to be high. In fact, this appears to be the reason
why since March 2011, yields on AAA rated corporate bonds have not risen as
much as government security yields.
Focus on the short-term, play it safe
Agreed, corporate bonds now appear a better bet than gilts.
But should investors buy short-term (1-3 years), medium-term (3-5 years) or
long-term options (5 years-plus)?
Those considering these options would essentially have to
take the mutual fund route, which offers all three kinds of products. The short
and medium-term funds appear better bets today.
Flat yield curve
While interest rates are expected to moderate from current
levels (See accompanying story on Interest rate outlook), the fall in policy
rates this time around may not be as steep as in 2008-09.
Gilt and long-term income funds, which bet on 5-year-plus
instruments, usually make the most capital gains from a fall in interest rates.
Shorter-term funds benefit more from interest rate accruals.
This suggests that moderate falls in interest rates would
make for limited gains on bond and gilt mutual funds. Investors, therefore, can
continue to look at short-term bond funds.
The other big reason why short and medium-term funds appear
good options is the flat yield curve. Essentially, short-term bonds (1-2 years)
today offer much the same yields as long-term bonds.
Under normal circumstances the yields on short-term bonds
should be lower than long-term investments, as one takes the additional risk of
interest rate volatility in the long term.
This suggests potential for yields at the shorter end to come
down (and bond prices go up) once the rate cuts are effected.
Dhawal Dalal, Head, Fixed-Income, DSP Blackrock Mutual Fund,
suggests investing in either short-term debt funds or the dynamic bond funds to
play this trend in 2012. Dynamic bond funds have flexibility to increase or
decrease duration based on the prevailing interest rates.
Look beyond returns
Fund managers, however, also warn it is best to play it safe
when it comes to corporate bonds.
AAA bond investments are the preferred choice. While AAA-
rated bond yields may decline to close the gap with gilts, bonds that enjoy
lower ratings may not see an equivalent dip in yields.
In fact, bond issues from NBFCs with credit ratings ranging
from AA+ to AA-, which offered high yields last year, are now trading lower
than their par value.
Highlighting the riskiness of these bonds, Canara Robeco's
Ritesh Jain says, “Slowing investment activity, deteriorating currency, lack of
clarity in Euro Zone and high cost of debt will continue to put pressure on sub-prime
corporate balance sheets. Hence the chances of credit downgrades increase.”
This suggests that while choosing a debt fund too, investors
shouldn't merely look at the returns. Portfolio risk is a key factor. Under
normal circumstances, the risky portfolio may give good returns as interest
receipts flow in, masking the risk.
But during periods of crisis, where corporates are facing
the risk of falling interest coverage and debt refinancing woes, these funds
may take a hit.
Dalal points out that given the open ended-nature of DSP's
debt funds, investors can exit anytime. This means the investments have to be
liquid to meet the demands of investors. Therefore, they predominantly invest
in banks' certificate of deposits and AAA bonds.
Source: http://www.thehindubusinessline.com/features/investment-world/article2801356.ece?ref=wl_companies
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