It's the right time to invest in short-term bond funds

In the last 24 months, the Reserve Bank of India (RBI) followed an easy monetary policy cutting rates by 175 basis points (bps) and infusing greater liquidity into the system. From 8% at the peak of the cycle, RBI lowered rates by 175 bps to 6.25% at present. Interest-rate cuts were possible as inflation was on a downward trend in this period declining from 7.5% in June 2014 to 3.5% in December 2016. Besides, the economy continued to remain sluggish with growth at sub 7%.

The government's decision to demonetize high-value notes in November 2016 led to a sudden surge in liquidity in the banking system. The combination of surplus liquidity post demonetization and an anemic loan-book growth forced banks to lower their lending rates by almost close to 100 bps, thus offering finer pricing to their borrowers.

As lending rates declined, banks have simultaneously lowered their deposit rates in a bid to protect their margins. This is reflected in falling bank fixed deposit (FD) rates in recent months. Historical three- year trailing returns on most of the short- and medium-term debt funds comfortably beat bank FD rates. However, it is equally important to assess likely return profiles for the future.

Even as current liquidity conditions are the best that we have seen in the last six years, longer tenor debt funds have been faced with some headwinds arising from a combination of factors. In its two policy meetings post demonetization, RBI has maintained 'status quo' on key rates. This is despite a surge in liquidity and a strong rally in short-term yields seen during this period. Obviously, RBI is looking beyond the short term and considers the liquidity build-up to be merely transient. From a medium-term objective, RBI now has set its eyes on lowering CPI to 4% on a 'durable basis'. While recent CPI readings have all been under 4%, a sustained lowering of CPI to 4% or lower, is likely to limit the room for sizeable rate cuts in the near to medium term.

On the external front, global rates led by US treasuries have been moving higher in the last three months, rising from 1.60% to almost 2.60% on the 10 year benchmark bonds. The US fed has also raised rates twice by 25 bps each in the last three months. At least two more hikes are expected through the course of the calendar year. Besides, inflation globally has also been making a comeback with oil having rebounded almost 100% from its February 2016 lows. Commodities have witnessed firmer pricing as well, helped in part by some global restocking and closures of capacities in China.

In balance, strong domestic macro conditions are partly offset by global uncertainties and are likely to limit the room for outperformance in longer debt products in the near to medium term. Given this background, we see greater value in short-duration products with tenors ranging from two-four years. While longer products would enjoy a higher carry, any volatility at the longer end could dilute overall returns as seen in the recent three- and six-month return comparisons for short and longer categories.

Investors could also consider 'accrual funds' in the current environment. Such funds benefit from a relatively higher yield as a larger part of the portfolio is invested in AA rated securities (as opposed to duration funds which are mostly invested in AAA rate securities) with some allocation to Single A rated securities as well.

Corporate margins and profitability are expected to start improving in the coming quarters from a combination of lower cost of capital, stable commodity prices and a gradual pick-up in demand conditions. This should fundamentally help restore balance sheets while supporting credit ratings.

Rating statistics of AA and single A-rated securities reflect relatively low degree of rating migration over longer periods of time. Investors in accrual funds can also benefit from active credit selection which optimizes payoffs for investors. Since these funds mostly maintain moderate duration (average maturity of two-four years), interest rate volatility is also low in these products, while the credit risk is minimised through effective diversification.

The writer is head – fixed income, DHFL Pramerica Asset Managers Pvt. Ltd.