Make Profit from the bond Market



As inflation dips and there's clamour for cutting interest rates, bond prices are rallying.

Here's how you can gain from this trend

The rapid decline in inflation in the past 4-5 months is good news for everybody, but debt fund investors should be particularly happy. Consumer inflation is now below the RBI's January 2015 target of 8% and very close to its January 2016 target of 6%, raising hopes that the apex bank will cut interest rates. Most experts believe rates will be cut by 50-100 basis points in the next one year. If interest rates are cut, the prices of long-term bonds shoot up. Mutual funds that have lined their portfolios with long-term bonds benefit the most.

In addition to falling inflation, the RBI is also under pressure to cut interest rates because the economic growth is refusing to pick up. In August, the index of industrial production rose by 0.4%.

The government has also joined the clamour for a rate cut. In an interview last week, Finance Minister Arun Jaitley said, "Now that inflation seems to be stabilising, the time seems to have come to moderate interest rates."

The market has already begun factoring in a fall in inflation and a subsequent rate cut. The benchmark 10-year bond yield is now at 8.3%, down from a high of over 9% in April this year.

This has pushed up the returns of debt funds. Several long-term gilt funds have generated terrific returns in the past 3-6 months. Experts say this is a good time to get into these long term debt funds to reap maximum gains from the bond rally. Long duration funds are a good option now and one can expect 14-15% return from them in the next one year

Though a rate cut is on the cards, several international and domestic considerations will be at play before the RBI governor, Raghuram Rajan, makes his move. Experts believe that the first rate cut will not happen before April next year. The RBI may wait for more policy reform measures before it starts acting.

The RBI is keeping a hawk eye on four major factors. First, the expected interest rate hike by the US Federal Reserve and its impact on global markets, especially on the Indian rupee. The concerns over the withdrawal of the Fed's bond buying stimulus programme had resulted in a major upheaval in 2013, with the rupee plunging to close to 70 against the US dollar. This had forced the RBI to increase rates and take other restrictive measures.

The second is inflationary pressure. The wholesale and consumer inflation are down due to a drastic fall in global crude prices and a high base effect, which is expected to wane by the end of this month. This will translate into a slight uptick in inflation from December onwards. The RBI will act only after assessing the December inflation numbers.

The apex bank will also keep a close watch on the government measures to reduce supply side problems. While the diesel decontrol was aimed at reducing the fiscal subsidy and, therefore, was a welcome step, the government is yet to take a call on other petroleum products, such as LPG and kerosene.

The Union Budget in February 2015 will be the other major event that would determine the rate cut decision. The fiscal deficit target for 2014-15 is optimistic, more so because tax collections are lagging behind the target. The RBI may also wait for clearer fiscal numbers before getting into the cutting mode. Therefore, don't expect a rate cut before the April review.

No fear of a rate hike

While the market also knows that the rate cut may not happen immediately, it has discounted fears of a rate hike. "The probability of a 25 bps rate hike has gone down from around 25% three months ago to around 10% now.

The other factor pulling down bond yields is the improvement in the government's financial position. The supply of government securities will reduce if the Centre sticks with its fiscal deficit figures. It may not be necessary for the government to borrow big time in the fourth quarter of 2014-15. The 10-year government bond yield has fallen by more than 40 basis points in the past four months

Then there is the slowdown in credit growth. With very few borrowers, banks have been forced to park their money in government securities and thereby increasing its demand. The large inflow of FII funds to the Indian debt market is also pulling down the yields. With the currency remaining stable in the `60-62 range, most of this money is flowing to India to benefit the interest rate arbitrage. After exhausting the government securities limit, this money has now started flowing into the corporate bond market. The RBI may be forced to cut rates and reduce the rate difference if the Indian markets are not able to absorb large inflow of arbitrage funds.

Medium or long-duration bonds

To gain from the bond rally, move out of short-term debt funds to long-duration funds. The returns from short duration funds will fall if there is a rate cut. These funds will be forced to invest in new investments and maturity amounts of old investments at lower rates. Long-term debt funds, on the other hand, will generate fabulous returns in a falling interest rate scenario.

With the current coupon rates of long-duration papers with over 10year maturity at 8.5-9%, these funds should be able to generate similar returns even if the rate structure remains stagnant for the next one year. Capital gains due to the fall in interest rates will also add around 5 percentage points to the returns if we assume a 50 bps cut. However, long duration funds are also more volatile. If your risk appetite is low, you can consider medium-duration (average maturity of 5-10 years).

Gilt or Corporate Bonds

Government securities are more sensitive to interest rates and, therefore, will be the first to move up when there is a rally after a rate cut. They are also free from default risk. Corporate bonds, on the other hand, generate better yields. However, experts say income funds are better because the fund managers can include both gilt and corporate bonds in the portfolio. Income fund managers can play the credit spread. Credit spread refers to the yield gap between gilt papers and AAA rated corporate bonds. Dynamic bond funds Selecting the right duration and exiting at the right time, however, may not be easy for all retail investors. If you think you may not be in a position to take a call on interest rates, go with dynamic bond funds. Here, fund managers will be taking the call on your behalf. Dynamic bond funds are a better option because static portfolios won't work in a volatile interest rate regime. Actively managed debt funds should do better than fixed duration funds in a 3-5 year time period. In recent months, fund managers of dynamic bond funds have increased the average maturity of their portfolios. From two years earlier, the average maturity is now around six years.

Selecting funds

To select good schemes, always stick with large-sized funds. The market lot size in the wholesale debt market is very high (around `5 crore) and a smaller fund may not be able to fully capitalise the emerging opportunities in the market. Also, smaller funds may face a tough time if there is sudden redemption pressure. The fund manager will have to resort to distress selling, which will hurt the fund's NAV. Also, make sure that the portfolio is not into lower rated bonds. Some fund managers try to improve their returns by including low-rated corporate bonds that offer higher yields. Stay away from such funds.

Think long term

Though the rate cut by the Reserve Bank of India is expected within the next six months, stay invested for at least three years for better tax efficiency. The investors with a six-month view should not be here. It becomes a trading call and, therefore, this involves a huge risk

If for some reason the rate cut is delayed, it can upset the applecart in the short term. Don't forget what happened during July 2013 when the RBI was forced to hike rates after a sudden depreciation in the rupee.

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