'Medium-to-long term bonds provide favourable risk-reward opportunity'

Bond market traders were unnerved after the central bank suggested that rising yields are here to stay. SAURABH BHATIA, head of fixed income at DSP Investment Managers tells Puneet Wadhwa that he expects next round of returns in fixed income instruments to be triggered more by demand – supply of bonds rather than cut in repo rates. Edited excerpts:

Debt funds witnessed an inflow of Rs 91,392 crore in July, reports suggest. Do you expect this pace to continue or will investors turn cautious as economic recovery remains fragile?

World over, the central banks have pushed the fixed income investor to add a layer of risk. If the reducing gap of returns between cash deployment and incremental short term investment sustains, investors will continue to add to next layer of risk, i.e. duration or credit. Yield curve is very steep, economic activity is muted, credit growth is still languishing at very low levels, while the deposit growth is going strong. Fiscal response is largely muted. This combination coupled with sustenance of super surplus liquidity has led to increase of flows into debt funds. Until we see reversals in above factors, interest rate regime will continue to remain benign and hence continue to attract more flows.

Franklin Templeton, which had high exposure to sub-AAA rated bonds, cited drying up of liquidity in bond market, which triggered panic among investors. How is the situation now?

Sensitivity to credit markets has indeed reduced courtesy held-to-maturity (HTM) enabled targeted longer-term refinancing operations (TLTRO) and sustenance of super surplus liquidity by the RBI. These measures have certainly aided to mitigate the extent of refinance risk for the respective issuers. That said, credit attractiveness improves as when we turn the tide on growth. As this turn looks less distant to where we were few months ago, the risks on a broad-based credit category are incrementally reduced.

Do you see a wider fiscal deficit by the end of FY21? What are the implications for the debt / fixed income segment?

Widening of fiscal deficit is inevitable. From the perspective of interest rates, fiscal deficit becomes a villain when it starts to positively impact growth. Presently, the fiscal response is relatively restrained and hence it’s bearing on growth is muted. Continuation of lower growth regime cannot turn the tide on interest rates thereby anchoring the benchmark policy rates at lower levels. Until the growth tide turns, the RBI is comfortable in maintaining high amount of liquidity, which inevitably supports the short-end of the yield curve. 

Fiscal expansion, which entails higher government borrowing, leads to higher rates in the longer end of the yield curve as government tends to borrow more by issuing longer-end bonds. This indeed pushes the longer end yields higher and is reflected through a steep yield curve. 

Yield curve presently being very steep denotes the prospects of capital gains as well as accruals are relatively lower in the shorter end of the yield curve as compared to medium-to long-end bonds. With large part of rate cuts behind us, we expect the next round of returns in fixed income funds to be triggered more by demand supply of bonds (RBI intervention) rather than rate cuts.

What's your advice to an investor who missed the bus in March 2020 and wants to start investing now?

The current steep yield curve and narrow credit spreads imply that medium-to-long bonds provide more favourable risk-reward opportunity. Herein, to suppress the volatility of marginally higher duration, we recommend to apportion investments between roll down and open-ended funds bearing flexibility to maintain higher duration. This will enable to capitalise on flattening of yield curve as and when it happens, courtesy RBI’s measures. We expect next round of returns in fixed income instruments to be triggered more by demand – supply of bonds rather than cut in repo rates.