Many debt investors can’t make up their mind about an imminent interest rate hike. Omicron threat has queered the pitch for them. When will RBI hike rates? How long will the rates continue to go up? Shivani Bazaz reached out to Pankaj Pathak, Fund Manager- debt, Quantum Mutual Fund, to get clarity on these questions. Pathak explained the likely policy actions and also what debt investors should do (and don’t do) in the current market. Edited interview
Money market participants believe a rate hike looks imminent. Do you share the view?
Yes. We agree with the thought that policy rates have bottomed out in this cycle and the next rate action will likely be a rate hike.
The current monetary policy is set up to deal with the economic crisis. Now, enough indicators are pointing that we are not in crisis anymore. Even the RBI’s assessment suggests that the economy is recovering at a steady pace. So, this level of monetary accommodation may not be needed; especially at a time when inflation is hovering around the RBI’s upper threshold and the US Federal Reserve is indicating a faster rate hike path.
The market looks divided on how long the rate tightening will last. Many believe the cycle will be short. What is your view?
We expect this to be a shallow rate hiking cycle. In the previous regime, the RBI kept the policy rate significantly higher than the rate of inflation. It did more harm than good to the economy.
RBI under governor Das has been very sympathetic towards the RBI’s growth objectives. As evident, it is not bound by the real rate framework and is not hesitant to keep real interest rates near zero or even negative for an extended period.
Unless inflation gets out of control, we do not expect the RBI to sacrifice growth by raising interest rates too much.
On the point of inflation, much of the recent high inflation is due to supply chain bottlenecks and one-off price adjustments. These should fade away over time. Thus, a long rate hiking cycle may not be needed.
Where do you see the repo rate by the end of the year? The policy repo rate is currently at 4.0%.
Based on our current assessment of growth and inflation, we expect a 50-75 basis points hike in the policy repo rate in the current year. This could lead the repo rate to 4.50%-4.75% by the year-end.
But with the new fast-spreading covid-19 wave, the outlook looks highly uncertain.
What about the benchmark 10-year yield?
Markets tend to pre-empt policy actions. The 10-year government bond yield moved up by more than 50 basis points last year without any change in the policy repo or reverse repo rate. Currently, the 10-year Gsec is trading at a yield higher than what it was before the pandemic.
In our opinion, much of the rate hike is already priced at the long end Gsec. So may not see a proportional increase in long term yields when the RBI actually hikes rates.
Many investors believe that the central banks may suck out the entire excess liquidity in the system. Will it lead to a crash in the market?
The current level of liquidity in the banking system is very high. It is even higher than what we had during the pandemic in 2020. Thus, as part of policy normalization, the RBI may suck out some of the excess liquidity. However, tightening liquidity too much could cause serious trouble to the financial markets and the economy. Thus, the RBI might keep the overall liquidity condition in a reasonable surplus.
Based on your assessment, where should debt investors put their money in the next one or two years?
Monetary policy is in a transition phase. Thus, interest rates could be highly volatile in the next 6-9 months. In this environment, it would be prudent for investors to stick to shorter maturity funds and not to lock into long term fixed deposits or long-duration debt funds.
With rising short term bond yields, we should expect the performance of liquid funds and other such debt fund categories to improve going forward. For investors who are risk-averse or have a short holding period, can go with liquid funds to park their surplus cash or their emergency fund corpus.
However, if one has a longer holding period and a slightly higher risk appetite to tolerate some intermittent volatility, one can look at dynamic bond funds which can respond to changing market conditions by changing the portfolio positioning.
As I mentioned earlier, bond yields have already moved up quite a lot in the last 12 months. This offers an opportunity for long term fixed-income investors. However, it comes with high risk and requires a longer holding period and a high tolerance for intermittent market risks.
Most investors bet on corporate bond funds, banking & PSU funds, floating rate funds in the rising interest rate scenario. Can they continue with them?
Yes. Investors can continue with their investments in these debt fund categories if that fits their broader asset allocation goals. However, be mindful of the duration (market risk) risk in the corporate bonds and banking & PSU Funds.
What should they think about long term debt funds and gilt funds? If they can afford to stay invested through the entire cycle, can they invest?
If you are an investor who buys and holds a bond till maturity, there is no real impact on your investment due to interest rate changes. Thus, if one could hold for a longer period, they can remain invested in the long term debt fund categories. However, given the high uncertainty over the pace and quantum of rate increases, it would be prudent to have a flexible approach in the long term debt allocation. In our opinion, dynamic bond funds are better suited for long term debt allocation than long-duration funds or gilt funds.
Do you have any special advice for our readers?
Interest rates are on a rising trend. It is a difficult market to generate capital gains from debt securities. Over the next 1-2 years, debt fund return could be very close to the interest accruals that the fund generates. Thus, investors should lower their return expectations from debt funds.
