Fixed income outlook: Indian bonds to remain in vogue for next few quarters

In the past two months, bond yields have drifted lower across the yield curve to the tune of 40-45 basis points (bps), despite the lack of policy rate easing by the Reserve Bank of India (RBI). Yields have been pushed down by the abundant liquidity and macroeconomic improvement and a slew of policy reforms by the government. As a result, capital gains have supplemented interest income on fixed income instruments and portfolios. We believe this is only the start of a downward cycle in interest rates - a process that is going to last for the next couple of quarters.

There has been some good news on the macroeconomic front. Inflation is trending downwards, with the average rate drifting from 8.2 per cent in the first half of 2014 to below seven per cent in the past four months, thanks to measures taken by the government to ease food inflation, place hoarding restrictions and limit increases in procurement prices. Easing global commodity prices, such as fuel, combined with a weak demand environment, have also helped diminish the producers' pricing power.

Headline Inflation has moved gradually lower to 5.5 per cent year-on-year in October 2014. The Reserve Bank of India has kept the focus on achieving of Consumer Price index-based inflation rate of six per cent by January 2016, rather than the immediate target of eight per cent by January 2015. The lower inflation reading may not be sufficient for RBI to initiate any policy rate cut in the upcoming policy meeting, as it prefers to maintain a sustainably low inflation instead of cyclical inflation. We expect to see policy easing coming in through 2015 to 7.25 per cent from eight per cent currently.

Although the fiscal deficit has exceeded 80 per cent of the annual target so far, subsidies in fuel, food and fertiliser subsidy appear to be under control, given the drop in commodity prices. A balanced approach on rural employment guarantee scheme has managed to contain overall social spend growth. Government spending has also shifted towards quality, which will be anti-inflationary and pro-growth. In the coming months, focus will be on monetising public sector holdings, auctioning of telecom spectrum and mineral rights, and increasing the tax base. These efforts are expected to help achieve the fiscal deficit target of 4.1 per cent, with a potential to reduce further.

Liquidity conditions have also improved post-elections, led by a strong demand for Indian bonds from foreign investors, RBI's efforts to stabilise the domestic currency and increased government spending. This is also the first time that foreign institutional investment flows into fixed income ($23 billion) outnumbered flows into equities ($14.5 billion). This foreign demand is expected to continue in the near term, led by improvement in macroeconomic outlook in India relative to other emerging economies.

There is no room for foreign institutional investors to buy more government securities, although corporate bonds offer further leeway of another Rs 100,000 crore. Demand could, thus, be skewed towards corporate bonds, with further yield spread compression against government securities. Any further significant shift in the mid- to long-end of the yield curve would be mainly driven by RBI's policy stance.

We prefer long-end (duration) funds, as higher sensitivity on the long-end helps generate superior returns on investment. We favour an overweight allocation to long-end instruments, through a combination of long-dated government and higher-rated corporate bonds, AAA-rated tax-free instruments and duration funds.

The author is chief investment officer, RBS Private Banking