Large part of interest rate rally is over

The Indian bond market has been in limelight, thanks to the near-zero rates in the developed markets. With the global investors chasing higher-yielding assets, the local bond market has thus far managed to attract Rs 11,300 crore ($1.7 billion) inflow this quarter itself. One of the major triggers aiding the positive sentiment has been the appointment of Urjit Patel as the Governor of Reserve Bank of India (RBI), thereby indicating a continuation in policy stance.

However, the moot question among investors now is: is the best over for the bond market? In order to answer this question, it is pertinent to look at the factors that can affect interest rates and check how each of these is positioned to have a meaningful outlook. Here, there are four key parameters that need to be considered - inflation, current account deficit, fiscal deficit and currency stability. Given the macro setting, the outlook remains positive for each of these four factors.

Two of the major events in the form of the US Federal Reserve and the Bank of Japan meeting, which could have had a negative implication on the bond markets are out of the way, paving the way for a sanguine outlook. Thus far, we have seen a 150 basis points cut in interest rates, bringing the real interest rates closer to RBI desired level. There has been a significant downward move of both the repo rates and yields in the market, ensuring a good investor experience over the past three years. However, the past 30-50-basis point fall in yield has been driven by RBI liquidity, thanks to the open market operations undertaken by the apex bank. We are of the view that this stance by RBI is likely to continue and, as a result, the yields in the market would continue to be benign. One needs to monitor the Foreign Currency Non-Resident (Bank) outflow and its implications on the currency, but RBI is likely to provide the much required liquidity.

Further, if inflation drops to below five per cent and stays there consistently, you cannot rule out another 25-50 bps rate cut over the next three-to-nine months. From that perspective, in the shorter term, the expectation would be for the yields to come down further. Here, it may be highlighted that rate cuts as witnessed in the past two years are unlikely to occur again. For an investor whose horizon is six to 12 months, there is merit in continuing to hold duration position. Even for someone wanting to take a fresh position for 6-12 months, there is room for a duration play.

From a three-year perspective, we are of the view that a large part of the interest rate rally has been harvested. From here on, it would be prudent to opt for products that don’t rely on interest rate movement to generate a significant part of the return. Therefore, accrual fund augurs well, in such a case. This is because in an accrual fund, considerable part of returns is generated through the yields of underlying securities rather than through interest-rate movements.

The author is head – structured and credit investments at ICICI Prudential Asset Management Company