Active debt funds gain edge over passives as rates peak: Vikas Garg

The repo rate is expected to remain high for a longer period as the domestic growth-inflation dynamics may not provide any room for rate cuts in 2023, says Vikas Garg, head of fixed income at Invesco Mutual Fund. In an email interaction with Abhishek Kumar, Garg adds that in the current scenario, the 3-7 year yield curve range is more attractive from a risk-reward perspective. Edited excerpts:

How has the Reserve Bank of India’s (RBI’s) latest policy announcement impacted yields?

RBI maintained a status quo on policy rates on expected lines drawing comfort from improved external resilience over the last few months and moderating domestic inflation trajectory even as the global monetary policy outlook worsened. The market, however, was marginally disappointed as the Monetary Policy Committee (MPC) maintained the policy stance as ‘withdrawal of accommodation’, given the uncertainties on the global monetary policy front as well as on monsoon. It sounded more determined to achieve the targeted 4 per cent inflation mark. Nonetheless, market reaction was muted, and yields hardened by a moderate 3-5 basis points (bps) across the curve. This is also to be seen in the backdrop of sharp overnight upward movement in developed market rates by 10-15 bps as Bank of Canada carried out an unexpected rate hike.

What should investors prefer right now — active or passive debt funds?

Passive debt funds have played a critical role over the last couple of years by providing steady returns even in the backdrop of rising interest rates. Now that the rates have peaked and the rate cut cycle will begin at some point of time, we believe active management has an edge over passive. Active funds can better capture the capital gains resulting from rate cuts.  

When do you see the rate cuts starting?

We expect the policy rates to remain high for a longer period as the domestic growth-inflation dynamics may not provide any room for rate cuts in 2023.While inflation has moderated, it is still expected to remain elevated at over 5 per cent in FY24 against the 4 per cent target. It may go up even further if the monsoon disappoints. Moreover, growth remains resilient, allowing RBI to focus on inflation. The rate cut cycle will also depend upon global monetary policies, especially that of the US. It is expected to start only after the beginning of rate cuts in the US, considering the narrow policy rate differential.    

When do you expect the yield curve to steepen?

The current yield curve is flat as compared to historical levels. The market expects rate cuts over the medium term, thereby protecting the longer end of the yield curve. Relatively higher G-sec demand over the last 2 months from mutual funds, insurance companies and few corporates has also supported the levels. The yield curve will see some steepening in the next 3-6 months. This is owing to record high fiscal supply for FY24 and the expected delay in the start of the rate cut cycle.

Should investors prefer shorter-to-medium horizon funds, given they are more attractive from a risk-reward perspective?

Investors can look at various points of the rate curve as elevated yields are expected to deliver positive returns over inflation.

More specifically, given the current flat yield curve, we find the 3-to-7 year space more attractive from a risk-reward perspective as this space will be less impacted by interest rate volatility. Credit environment remains healthy. However, the current narrow spreads of AA / AA+ over AAA bonds do not provide favorable risk-adjusted reward opportunities.  

What is the 'duration' positioning of your debt fund portfolios? Has the latest policy update brought any change?

Fundamentally, we have been constructive on interest rates since February 2023. Accordingly, we have been maintaining a neutral-to-overweight position on duration across most of our schemes. We will look to add further duration if the rates harden. Any significant deterioration in global or domestic inflation trajectory will warrant a cautious stance on interest rates.