With the notable fall in bond yields in the past month and the RBI holding rates in its monetary policy on Tuesday, the rally in bond market is likely to be limited from here. Bond yields that were stubbornly high at 7.7-7.8 per cent through most of 2015 have fallen sharply since February, first on the back of the Centre’s adherence to the fiscal deficit target and then on the RBI’s 25 basis point rate cut in the April policy. The RBI’s increased open market operations (OMOs)-- buying of government bonds, has also helped suck out the excess supply of G-Secs, leading to a bond market rally. In anticipation of monetary easing from the major central banks, the rally in bond markets intensified post the ‘Brexit’ vote. In the month of July alone, the yield on the 10-year G-sec has fallen by about 30 basis points.
Lower stimulus measures
With stimulus measures by major central banks not having the desired impact, aggressive monetary easing is unlikely from hereon. This could lead to a rise in the yields in bonds in developed markets, leaving little room for a further fall in yields in the domestic bond market. According to Abheek Barua, Chief Economist, HDFC Bank, historically, the spread between the US and India 10-year benchmark bonds has been around 550 basis points. With the recent rally, the spread is now close to its historical average. As yields pick up in the developed world, the spread could compress further, leaving limited downside for Indian bond yields, he adds.
Also with risks in meeting the CPI inflation target emerging, rate cuts will be limited from hereon. The RBI can at best cut its key policy repo rate by another 25 basis points this fiscal. The yield on the 10-year G-Sec, is likely to hover around the 7.1-7.2 per cent levels going ahead.
What for investors?
So, what should bond investors do now? Given that the bond rally will be limited for the rest of the year, investors who have already invested into gilt funds can take some profits off the table. After a lacklustre performance in 2015, gilt funds have delivered about 11 per cent returns in the past year. For those sitting on the sidelines, it would be wise to invest in short-term debt funds or in dynamic bond funds that have the flexibility to switch between short-term and long-term bonds.
Investors should however stay clear of the riskier corporate bond funds, particularly those investing a chunk of their assets in low-rated bonds.