Duration funds likely to offer 12-14% return: What should your 2024 strategy be?

With high starting yield and expectation of fall in bond yields, long term government bonds offer investor a rewarding opportunity, said experts

The year 2024 will be the comeback year for the Indian debt market as growth-inflation dynamics favour debt markets globally. Long-duration debt funds are aptly placed to deliver double-digit returns, according to brokerage ICICI Direct.

2024 is likely to witness sharp slowdown in major economies like the U.S. and China while growth in the Euro region is also likely to be sub-optimal. Resultantly, inflation is also likely to normalize post geo-political disruption.

Source: ICICI Direct, Bloomberg

Moreover, the rate-hiking cycle has peaked and the rate-cutting cycle is about to begin. Inflation is cooling off along with slowing global growth. High interest rates, declining growth and heightened geo-political tensions have increased the risk of financial or economic shocks, while domestic demand-supply dynamics in the bond market is looking more favourable with robust tax collections, the government’s fiscal consolidation plan and India’s inclusion in the global bond index.

 

Monetary Policy – Heading for Reversal

Heading into 2024, central banks’ tone has begun to shift and the US Fed has now readied itself to talk about rate cuts. The Dot plot below which indicates FOMC members’ projection for the Fed Funds rate, is now showing about 75 basis points (100 basis points = 1%) of rate cuts in 2024. ( Source Quant AMC)

US Rate setting panel (FOMC) is indicating 75bps rate cut in 2024

Source – Bloomberg, Data as of December 13, 2023

Yellow dots represent each FOMC members’ projection of future Fed Funds Rate; the green line shows the median estimate for the same.

Global rate-cut cycle in the offing

Government Bond Index inclusion: A game changer

India will be included in the JP Morgan GBI EM Index starting June 2024 with an eventual 10% index weight to be reached by March 2025.

ICICI Direct estimates that JP Morgan’s Bond index inclusion could alone lead to FPI inflows of $25b billion or Rs 2 trillion in the Indian debt market, while FPI share in government borrowing may rise to 10-15 per cent in FY25, the highest since FY19.

Source: ICICI Direct

"Index inclusion can open a source of consistent demand for Indian bonds from investors who track the index, particularly from the exchange-traded funds or ETFs. Even active investors will be more comfortable investing in India when it becomes part of the index," said Pankaj Pathak Fund Manager, Fixed Income, Quantum AMC.

Apart from JP Morgans GBI-EM-GD index, Bloomberg Global Aggregate Index(Global Agg) is also likely to include Indian bonds in its index. It has an estimated AUM of $2.5 trillion and with 0.6%-0.8% weight, additional potential inflows could be $15-20 billion. 

"Such inflows coinciding with global rate cut cycle is likely to push bond yields lower resulting into lower cost of funds for Indian corporates," noted the brokerage.

Apart from the direct impact of additional demand, there could be spill-over benefits as well, as explained by Pathak:

1. The new demand source for government bonds might also help in deepening the corporate bond market in India.
2.  Potential foreign inflows into Indian debt will expand the source of foreign capital which in turn will strengthen India’s balance of payment situation and deepen the market for the Indian Rupee.
3.  Foreign holding of bonds would enforce much stricter discipline on the fiscal and monetary policy.
4. Increased participation by foreign investors, would enhance the credibility of the Indian bond market and will make it easier for the government and the corporate sector to raise debt capital from global investors.

FPI Global bond index inclusion-related buying is already visible

Foreign investors have bought a net Rs 33500 crore in Indian Government Securities under freely accessible route (FAR) since 22 September 2023 (when the announcement of the inclusion of Indian bonds in JP Morgan Global Index was announced) till 27 December 2023, indicating index-induced buying has already started. 

So far in 2023, foreigner investors (FPI) have been consistent buyers in the bond market with a net purchase of Rs 568 billion ($ 6.83 billion) of government bonds (data upto December 19, 2023). "We expect the pace of foreign buying in Indian bonds to increase in 2024 with the global interest rate changing course," said Pathak.

India: Expected Rate cut: 75bps…Yield could move down 100bps

India's Reserve Bank of India ( RBI) is likely to cut rates by 75bps from the later part of the year 2024. "Historical spread of 75bps of 10- Year over Repo rate could further move lower to around 50bps on the back of FPI Flows. Effectively, while the RBI rate cut could be 75bps, the 10-year yields could potentially fall by around 100bps from the current level of 7.20 per cent to 6.25 per cent," said Pankaj Pandey, Head of Research at ICICI Direct. 

Point to note: In previous two rate-cut cycle, the rally in government bonds preceded the actual repo rate cut by RBI. In 2015 rate-cut cycle , the 10-year G-Sec yield declined by around 115bps between April 2014 till January 2015. The total rate cut during the cycle was 200bps. Similarly, 10-Yr G-Sec yield declined by around 70bps during September-December 2018 before the start of the rate-cut cycle in February 2019, which last for 135bps.

In the 2015 rate cut cycle, the 10-year G-Sec yield declined by around 115bps between April 2014 till January 2015. The total rate cut during the cycle was 200bps. "Yields started moving down in 2014, well before the start of the rate cut cycle which started in 2015. The return during the 1-year period from April 2014 to March 2015 (pre-rate cut period) was around 15 per cent," noted the ICICI Direct report. 

In 2019 rate-cut cycle , the 10-year G-Sec yield declined by around 190bps from September 2018 till July 2019. The total rate cut during that period was 135bps. The return during the 1-year period from September 2018 to September 2019 was around 16 per cent. 

The year 2024 could offer a 12%-14% return in duration funds

"Debt market perform in cycles. Every down-cycle is followed by an up-cycle. During the current up-cycle which started from June 2022 when 10-year G-Sec yield was around 7.6%. The rally in the current cycle has just started which may last another 12-15 months with yield moving down towards 6.25%. Annualised return during the current cycle could be around 11% with incremental return in the year calendar year 2024 around 12%-14%," said Pandey.

What should investors do?

"With high starting yield and expectation of fall in bond yields, we believe that long-term government bonds offer investors a rewarding opportunity. Dynamic Bond Funds are probably best placed to capture this opportunity with the flexibility to change if things don’t pan out as expected. However, investors need to have a longer holding period of at least 2-3 years to ride through the intermittent volatility," said Pathak.

Investors with shorter investment horizons and low-risk appetites should stick with liquid funds.

For those looking for long-term double digit returns, ICICI Direct recommends HDFC Long Duration Debt Fund, Nippon India Nivesh Lakshya Fund and SBI Long Duration Fund.