Debt investors still have plenty of room for gains

The going has broadly been good for the debt market in the past year. The only hitch is that Indian investors are still under-invested in debt assets. Having invested in gold and real estate for the better part, household savings are hardly invested in financial assets and mutual funds (MFs). Data show that MFs constitute only two-three per cent of household savings. Total debt fund AUM (assets under management) in the country is less than 10 per cent of bank deposits, despite the superior tax treatment of the former.

Having said that, over the past year, investors have been warming up to debt funds and that's a good sign. Debt investors stand to gain a lot from the cut in interest rates. The Reserve Bank of India (RBI) has cut the policy rate by 50 basis points, but that is not the end of the rate cut cycle.

Global disinflationary cycle is underway. Prices of commodities, including crude oil, are down 50 per cent from their peak and are likely to remain subdued in the coming quarters. Globally, most economies are witnessing their Wholesale Price Index in negative zones. This will contain the inflationary pressures in India, too.

In the recent credit policy, RBI set a new inflation target of 4.5 per cent for March 2017. RBI has also indicated that it will have an accommodative stance on monetary policy. Hence, one can reasonably argue there will be further rate cuts.

All this bodes well for debt funds. While the benefits for gilts funds from interest rate cuts are obvious, credit funds that invest in corporate bonds also stand to benefit from the current higher yields on corporate paper. As interest rates come down, these yields are also likely to come down, especially in a scenario where credit growth has been lower.

Some people have been worrying about the state of the credit market, of late. In reality, credit profiles have turned healthier from a year ago. Credit ratios published by credit rating agencies have been steadily climbing higher over the past few years. The upgrade-to-downgrade ratio, as published by CRISIL, has improved sharply in FY15 and currently stands at 1.75 - indicating almost twice as many upgrades as downgrades.

An improving credit ratio adds to the return of credit funds. Having said that, recent events prove that investment in a corporate bond needs a bottom-up analysis rather than just relying on external ratings. Also, the size of exposure on a corporate group (called concentration risk) needs to be limited to contain any impact of adverse movements in credit ratings.

Nevertheless, rating upgrades and downgrades are a part of life and therefore investors should look at the aggregate picture and not worry about one specific downgrade. Investors in equity funds have internalised that in an equity fund, some stocks will go up and some will come down but what matters is overall performance. Similar maturity is needed while investing in debt funds with credit papers.

Where do we go from here? We believe there is scope for further rates cuts going forward. Also, the interest rate cuts already carried out by RBI have not yet been fully transmitted into the economy. As such yields should continue to be headed lower. This would not only reduce the interest burden for companies but also improve the country's business outlook. This would in turn mean strengthening of corporate balance sheets, improving credit ratios and better performance of funds investing in corporate bonds. Given the possibility of further rate cuts and improving credits ratios, debt funds continue to present a compelling investment opportunity.

The author is head - structured and credit Investments, ICICI Prudential AMC