Fixed income remains a low-hanging fruit

When the Reserve Bank of India (RBI) cut interest rates back in January, it came as a pleasant surprise for the markets. With the interest rate decline cycle underway, good days are likely for fixed income investors. But let us reiterate that we were sanguine about the prospects of fixed income in 2015 way back in the second half of 2014, due to significant improvement in the macro indicators of the economy.

The Reserve Bank of India (RBI) in its earlier monetary policy review had held back on cutting interest rates, citing transmission of rate cuts, fiscal concerns, inflation trajectory and a possible tightening of US monetary policy. Most of these are moving towards a benign phase and there's a possibility that RBI might oblige with another rate cut.

Banks have started passing on the rate cuts by lowering their base lending rates. With credit growth slowing to single digits and looking subdued, they are likely to reduce lending rates further. Higher credit growth is needed to revive capital investments.

Second, the fiscal environment has improved dramatically, with the government's fiscal deficit at four per cent of the gross domestic product for FY15, against an estimated 4.1 per cent, a clear positive for the macro economy. A tight fiscal policy shores up confidence in the government's finances and helps pave way for a rate cut. Besides, the current account deficit is expected to remain below one per cent of gross domestic product for FY16, again due to lower crude oil prices.

Inflation continues to be under control. In April, Consumer Price Index-based inflation was 4.9 per cent, compared with 8.15 per cent a year ago. We believe average inflation is likely to settle at around five per cent but there could be some sharp movements due to base effects.

If inflation expectations further moderate, the market might start to price in more and more rate cuts, in which case we might see yields of 10-year government securities (G-Sec) going below 7.25 per cent. As of now, with inflation averaging at five per cent for the year, steady growth and expectations of a stable monsoon, yields could settle at 7.35-7.60 per cent in the current financial year.

Looking at the current macro economic fundamentals, we believe interest rates are at a much elevated level. With inflation likely to moderate, government fiscal data continuing to consolidate, low credit demand and the currency remaining stable, RBI could further moderate its monetary stance. There is a likelihood of at least another 50-75 basis points rate cut.

Bond funds with a higher maturity and duration funds seem better placed in a downward rate cycle. But for those looking to diversify, a debt portfolio with short- and medium-term bond funds can be a good combination as well. This is a suitable time to invest in such products, to benefit from falling interest rates and also limit the re-investment risk.

The author is CIO - fixed income, ICICI Prudential AMC