Debt outlook: Go for high-duration funds

Since the previous time we checked, when debt markets were pulled off high horses in June-July 2013, the volatility has shaped into a less-pronounced range. Debt markets are purely a function of what course the interest rates in the country would follow, which in turn are tied to the apron strings of inflation and a host of global and indigenous factors.

The Reserve Bank of India (RBI)'s duel with inflation is taking a favourable course and consumer price inflation would hover around 7-7.5 per cent through the year. There would be a breather in October-December 2014 tapering to as low as 6.5 per cent and then might gradually inch up.

Inflation cannot stay in the system for long, with the current account deficit (CAD) on its road to recovery because demand for money will reduce and a better current account for the economy translates into higher savings, which typically tends to force lower rates.

In the recent RBI monetary policy review, a status quo was maintained on interest rates. RBI will keep the stance hawkish and cautious but one has to wait for the policy in June to get more information and clarity on uncertainties around elections and the monsoons for further direction on policy.

Even so, as there would be reform from the new government and adherence to the fiscal responsibility mandate, the economy would witness low inflation in the next two-three years and that will only drive down the rates in times to come.

With CAD expected to remain within two per cent of gross domestic product and with continuously improving outlook on India, we believe the rupee is likely to stay stable at 61-62 a dollar. RBI's effort to shore up foreign currency reserves will only stop the rupee from appreciating.

A higher-maturity segment offers the best value at this point in time, given the yields in the 10-year plan are about nine per cent. The margin of safety is the highest in high-duration segment and, therefore, we recommend investment in high-duration products such as income fund and gilt fund. Even for investments in the fixed-maturity plans, one should try to participate in two-year and three-year products.

For an investor with a longer-term investment horizon and one who wishes to continue investing regularly, a monthly income plan is another good product, as it will tide out the short-term volatility of equity and fixed income.

Investors can look to invest in dynamically-managed debt funds with a medium- to long-term perspective. Flexibility to alter the stance of the portfolios depending on evolving macroeconomic environment makes a dynamically managed income fund an all-weather fund. Because of falling bond prices (inversely related to interest rates), which affect net asset value of debt mutual funds, the biggest mistake investors tend to make is exiting the duration or maintaining passivity at this point in time. Rather, this is the time to further increase allocation on duration funds.

The author is chief investment officer - fixed income, ICICI Prudential AMC