Should you buy bonds? Axis MF sees near-term rally if RBI avoids tightening

Axis MF advises bond investors to gradually add Duration as RBI may avoid aggressive rate hikes despite oil risks and inflation concerns

Bond market strategy amid high oil prices, weak rupee

  India's bond market may be entering a more challenging macro environment as rising crude oil prices and geopolitical tensions alter inflation and interest-rate expectations, but bond investors should resist the urge to turn defensive and instead use volatility to gradually build duration exposure, according to Axis Mutual Fund. 

In its latest fixed income strategy note, the fund house said India is moving into a “materially different macro regime” from previous oil-driven stress episodes such as 2013, 2018, and 2022.

  The ongoing Middle East conflict and a sustained rise in crude prices beyond the Reserve Bank of India’s (RBI’s) assumptions is creating simultaneous pressure on inflation, the rupee, growth and fiscal balances.

 

  For India, the challenge is amplified because of its structural dependence on imported energy, the find house said. 

India imports nearly 85 per cent of its crude requirement, making the economy highly sensitive to oil shocks. According to its estimates, every $10 increase in crude prices can widen the current account deficit (CAD) by around 40-45 basis points of the gross domestic product (GDP), lift inflation by 45-60 basis points, and increase fiscal pressure if fuel taxes are cut to absorb the shock. 

  "Yet, unlike earlier cycles, India entered this phase from a position of relative strength, supported by lower private leverage, healthier banks, stronger foreign exchange reserves, improved fiscal credibility, global bond index inclusion, and deeper domestic financial savings," Axis MF said. 

  Against that backdrop, the fund house recommends fixed income investors not to retreat from duration.

  "Investors could buy fixed income assets, but gradually," the fund house said.

  It added: "Markets appear excessively pessimistic in the near-term. If the Reserve Bank of India (RBI) opts for a pause after measured tightening, avoids emergency liquidity tightening or signals growth support -- bond yields could rally in near-term by 20-25 basis points."

  According to Axis MF, investors may consider a measured addition to duration exposure under three conditions: RBI avoids panic tightening; crude prices stabilise; and policymakers introduce measures to attract dollar inflows.   Check - TOP GAINERS NSE | TOP LOSERS NSE 

What are fixed income (bond) markets pricing in?

Yields on 10-year Government bonds are holding the 7-per cent mark, suggesting that the bond markets appear positioned for a much more aggressive policy response.

  Axis MF said overnight indexed swap (OIS) markets are pricing nearly 75-100 basis points of rate hikes, government securities are carrying elevated term premiums, corporate bonds reflect tighter liquidity expectations, while money markets are pricing possible liquidity-tightening measures. 

  However, the fund house believes markets may be overestimating the extent of tightening.

  Its base case is that RBI is unlikely to respond to rupee weakness with a 2013-style aggressive rate-hike cycle.

  "Instead, the central bank could adopt a broader policy toolkit combining measured rate actions of around 25-75 basis points, liquidity management, foreign exchange intervention, and administrative measures aimed at attracting dollar flows," the report said. 

  Those could include NRI deposit incentives, sovereign-style dollar mobilisation programmes and overseas issuance by lenders and public sector entities. 

  Axis MF added that sharp tightening alone may not solve the current challenge.

  "INR depreciation cannot be solved purely via rate hikes. Aggressive hikes may damage growth trajectory for India as oil shock is supply-side, not demand-side. Thus, higher rates may weaken growth without materially stabilizing INR," the report said. 

 

What did RBI do during previous oil shocks?

  During the 2013 "Taper Tantrum" episode, rupee stability emerged only after RBI introduced FCNR deposit measures to attract foreign currency inflows rather than through liquidity tightening alone. 

  Meanwhile, during the 2018 oil spike, the RBI announced a rate hike (including repo and margin standing facility) of 50 bps. In 2022, the RBI front-loaded repo hikes (up 250 bps), and revered the Covid-era low interest rate cycle regime. 

That said, Axis MF cautioned against becoming aggressively long duration.

  "India may be transitioning away from a ‘Goldilocks macro’ phase of low oil, benign inflation and stable deficits, as elevated crude (above $90), rising fiscal risks, potential continuity of INR weakness, and persistent imported inflation may keep macro risks alive," Axis MF said. 

  Hence, while the near-term view is tactically positive on duration, structural duration conviction remains moderate. 

Source: Axis Mutual Fund

  Its suggested investors maintain neutral-to-slightly long duration in the next three months, add duration after the first RBI action over three to six months, and extend portfolio duration further over six to twelve months if crude falls below $75 or long bond yields move above 7.9 per cent.     ===========  Disclaimer: View and outlook shared on the stock belong to the respective brokerages and are not endorsed by Business Standard. Readers discretion is advised.