Investors were attracted towards investment in bonds during the year 2011 with an increase in an interest rate. The interest rate is expected to be cut down in coming months; the question is what would be the outlook of a bond market in such scenario?
Interest rate outlook
Recently, RBI had cleared its view to stop the further increase in an interest rate. Investors are expecting it to come down gradually in the coming months, and so they are putting a stake for the bond market in expectation of good return.
The Repo rate is expected to cut down by 50-100 basis points in next 12 months. Though rate would not fall drastically at once, but it will start coming down gradually from somewhere around April 2012. The decision on rate cut would be extremely influenced by Inflation situation in the country. The food inflation has come down slightly in last few weeks, but the manufacturing price is still a matter of concern. The increase in crude oil price and expected electricity rate hike would further push manufacturing prices to higher side. The global commodity price has already started cooling down but the depreciation in value of INR against Dollar has neutralized all the benefits due to increased import bill.
Time not right for gilts
Benchmark 10-year gilt yields had touched the peak of 9 % in November 2011, and then it fell down to 8.26 per cent recently. Still, it does not seem good time to enter the gilt market for two reasons:
- The government has failed in containing the fiscal deficit, as expected in the starting of the financial year. Hence, the gilt price would further come into pressure, and yield will go up. In 2011, government had promised for strong disinvestment measures and cut down in spending. The current pictures show the failure of government's expectation as already it has increased the borrowing by close to Rs 92000 course for this fiscal, which is much beyond the budget expectation.
- Two, banks are expected to cut down investment in government bonds if the credit off-take improve in coming days; Therefore, lower demand would put pressure on government bonds.
The only way through which an investor can invest in the government bonds is through gilt mutual funds. The interest return from the gilt fund has shown extreme volatility; Ten-year gilt’s return had varied from 5 percent to 9 percent in last five years. The gilt fund has given an average return of 6% in last five years. Judgment of correct time is very important while investing in the guilt fund.
The risk avoiding investors can also opt for the quasi-government upcoming tax-free bonds of HUDCO and infra bonds of REC, PFC and IDFC, etc.
Interest rates of around 8 per cent for tax-free bonds are quite impressive for a high net-worth investor.
Corporate debt better
The long term gilt funds are not looking attractive in present situation, on the other hand corporate bonds are looking very attractive for investment. The leading and top-rated corporate bond is expected to do better than the gilts for following two reasons:
- The financial condition of the corporate is looking better than the government. The corporate are cutting down its expenses aggressively, whereas the government is still adding on borrowings; top Indian companies have been cutting back on their investment plans, reducing debt on their balance sheets and hoarding cash. The government lacks the smart financial planning. Any issuances by the corporate is, therefore, likely to be quickly picked up by institutional buyers.
- The corporate is looking for expansion, and therefore, they are coming with bonds for financing whereas the government bond is meant to reduce the deficit burden.
Suitable duration of fund
Now we come to an agreement that corporate bond seems better for investment than gilts in the present scenario. The question now is whether an investor should buy short-term (less than three years), medium-term (three to five years) or long-term corporate bonds (more than five years)?
The investors need to invest through the mutual fund in any case. At present, the short and medium term investment is looking attractive for the investors.
Flat Return from Gilt
The interest rate is expected to come down in coming days. Though the rate may not fall as it had corrected in 2007-08, but fall is there in the card.
Gilt as well as long duration funds, which are based on more than 5 year duration instruments, earns capital gains from falling interest rates. Short duration funds gains from interest income. Hence, it is evident that little fall in an interest rate would have fewer benefit on bond and gilt mutual funds. Investors, therefore, can continue to look at short-term bond funds.
Normally, the yield on short term fund should be lower than the long term fund due to extra risk associated with the longer duration such as interest rate uncertainty.
It means that once the interest rateis reduced then yield from the shorter duration fund would come down. Looking at the various points discussed above, the Dynamic bond funds are expected to be in demand in the year 2012 due to its flexibility to change the duration based on the existing interest rates.
Look beyond returns
It is always suggested to be cautious while investing in the corporate bonds. AAA bonds should be preferred over –AAA rated bonds. An expectation of a further slowdown in the economy cannot be eliminated as the Euro-zone crisis and global economic disturbance is still inherent in the market; hence, the funds may come under credit downgrade if the situation further degrades.
Therefore while investing, the investor should not only focus on the return but also ascertain the risk associated with it.
In normal condition, the high risk portfolio can give higher return by overshadowing the risk. But when the market condition is not up to the mark and corporate are facing deep financing problem then return falls dramatically. It is suggested for all the investors to invest in highly rated bonds for good return and less associated risk.