Should investors opt for higher debt allocation in the next 12-18 months?

Historically, bond yields have traded in a band of 6-8% on an average given that inflation too has stayed in an range of 5-7% over the last decade.

India bond markets have witnessed volatility in the last few months. The yields on the 10-year government bonds fell from 7.45% to 7% and have risen back to 7.25-35% due to the rise in US bond yields and crude prices in the recent past. Axis MF believes the market dynamics are changing from 3 facets :
 

• Fundamental - Macro picture highlighting the case for adding bonds.

• Structural - Changing market demand-supply dynamics & a case for long bonds (Duration).

• Relative – Perspective from history highlighting the outperformance of bond markets over other asset classes.

Why it's time to add more bonds, as per Axis MF: 

 

Inflation: Headline inflation is at 5%. The decline in core inflation continues and this could likely go below 4.5% as slowing growth in China and the weak global economy will likely keep commodity prices muted.

Growth : India’s GDP growth seems to be peaking off and could remain subdued at sub-6 % levels over the next two years. This is due to the fall in fiscal impetus by the government and weakness in global economies.

Favourable External Position: India’s external position remains comfortable considering the trinity (Forex reserves, balance of payments and current account deficit). Is China’s loss India’s gain? – Perhaps yes!

Narrowing US - India interest rate differential: To combat the pandemic, the US government increased spending to unprecedented levels leading to wider fiscal deficits (from sub 3% to 8-10%), a significant expansion of the US Fed balance

sheet from $1-$2 trillion and an easy monetary policy stance for 2.5 years.

The resultant impact of easy fiscal and monetary policies over the last three to five years has led to strong growth and an inflation spiral. 

In the last 12 months, the US Federal Reserve hiked interest rates to the tune of 500 bps and shrank the US Fed balance sheet from $3trillion to $1trillion.

"The narrowing interest rate differential has kept RBI on tenterhooks. However, unless we see a large depreciation in the rupee or higher outflows, we do not expect RBI to raise interest rates. RBI has already engineered a 25-bps rate increase in the last two months through tight liquidity conditions. Therefore, bond markets are pricing in most of the negatives, macro theme augurs well for bonds, and fundamentally, the rates cycle looks positive," said Axis MF.

What about bond yields?

The question that arises for bonds is high Fiscal deficits and large government bond supply, which in turn raises concerns about bond yields.

"If we analyse the trend over the last seven years, we have generally witnessed a structural demand-supply gap of Rs 50,000 to 1.5 lakh crore every year, where supply was higher than demand, which in turn is met by OMO purchases by RBI.
 

Nonetheless, in the last few years, there has been a growing trend of a significant increase in AUM/flows with Real money investors from Rs 55 trillion to Rs 85 trillion. This has been helping to fill in the massive demand-supply gap despite huge government borrowing plans over the last few years," noted the Axis MF report. 

Growth in Capital Stock with real money investors

In addition, Axis MF expects the fiscal deficit to normalize over the next three years from 6 per cent to 4.5 per cent and hence does not expect a significant jump in borrowing numbers.

" Also, with India Sovereign bonds being included in JP Morgan Global indices we expect $25-30 billion of flows in the next 12-18 months, this is almost equivalent to more than 20% of next year’s gross borrowings. This inclusion would be highly favourable for demand supply dynamics for bonds. Active bond traders could also pile into debt assets in the run-up to the scheduled inclusion by allocating roughly $5-10 billion by March 2024," it said. 

While bonds are always looked upon as an asset class that provides stability over a longer period, surprisingly and contrary to opinions, debt has outperformed other asset classes over the period’s extreme/long interest rate hikes and

 tight financial conditions.

Why Axis MF believe that 7.25-7.35% levels for 10 years IGB’s and above is a good time to add bonds to the portfolio

Historically, bond yields have traded in a band of 6-8 per cent on average given that inflation too has stayed in a range of 5-7% over the last decade. The inflation theme has structurally undergone changes wherein the range for CPI has changed from 5-7% historically to 4-6% range. Adding a term premium of 125-150 bps over the expected inflation band, Axis Bank Mutual Fund believe that Indian Government bonds offer an attractive carry and investment opportunity at current levels.

A few macro risks that stand out are rising crude oil prices, China's recovery and a possibility of China devaluing its currencyto attract flows.