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From a low of 7.01 per cent on March 11, the benchmark 10-year government security (G-Sec) yield rose to 7.19 per cent on April 16. Investors who have bet on longer-duration debt funds hoping for mark-to-market (MTM) gains are anxious today.
Spike driven by global factors
Global developments have led to the rise in the 10-year G-Sec yield. “It has been led largely by geopolitical risks, which have affected crude prices and the currency. Another factor is strong US data, which has delayed US Federal Reserve (Fed) rate cut expectations and led to a rise in US treasury yields,” says Devang Shah, head-fixed income, Axis Mutual Fund.
GDP growth projections in the US are getting revised upward. Inflation is proving stubborn. Rising US bond yields are driving domestic yields up.
US rate cuts: Fewer, later
Expectations regarding rate cuts by the Fed are getting revised downward. “The market was earlier pricing in three rate cuts this year but now expects two,” says Pankaj Pathak, fund manager-fixed income, Quantum Asset Management Company.
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The quantum of cuts has also been readjusted. “From an initial expectation of 150 basis points (bps), the expectation has now been pared to 50 bps,” says Joydeep Sen, corporate trainer (debt markets) and author.
Pathak expects rate cuts to happen in October and December.
Favourable G-Sec demand-supply
Delays in rate cuts by the US Fed are causing similar postponements and dialling down of expectations in India.
Experts say the scope for cuts exists. “The average inflation expectation for India in FY25 is 4.5 per cent. The operative rate is at 6.5 per cent, providing room for the Reserve Bank of India (RBI) to adopt a dovish stance,” says Shah.
Yields may also soften due to the positive demand-supply balance. “The government projected a reduced supply of government bonds this year in the Budget. Supply may decline further over the next two to three years. Meanwhile, strong demand is coming from insurance companies and pension funds,” says Pathak.
The inclusion of Indian G-Secs in foreign bond indices is expected to drive demand. “Indian G-Secs have been included in JP Morgan indices and the Bloomberg Emerging Market Index. Together they will lead to $20 to 25 billion of flows. Part of this money has already come in. Another $15-20 billion is expected in the second half of this year,” says Shah.
Two factors causing concern are volatility in food inflation and possible hardening of crude prices.
Experts believe October is the most likely date for the start of rate cuts. “In India, inflation could fall below the RBI’s target in Q3-Q4, potentially leading to markets pricing in rate cuts if the US Fed starts lowering rates,” says Shah.
Shallow cycle
The rate cut cycle is likely to be shallow—not more than 50 to 75 bps. After recent developments, Sen says, it is more likely to be 50 bps. “The projected average inflation of 4.5 per cent and the repo rate of 6.5 per cent are resulting in a positive real interest rate of 200 bps. If it is assumed that the RBI will be content with a 150 bps positive real interest rate, a 50 basis point rate cut appears feasible,” he says.
Hold on to your positions
Investors who have bet on longer-duration debt funds for tactical gains need to be patient. “They may need to wait for 6 to 12 months for these gains due to possible delays in rate cuts,” says Shah.
They should also have moderate expectations vis-a-vis MTM gains due to the shallow nature of the rate-cut cycle.
Pathak says those investing in longer-duration debt funds must have an investment horizon of at least three years to be able to cope with intermittent volatility.
Exposure to these funds should be limited. “Younger investors with higher risk appetite may take an exposure of as much as 50 per cent to longer-duration bond funds. Older investors and those with low-risk appetite may take up to 20 per cent. Conservative investors may avoid them altogether,” says Sen.
