Over the last year, interest rates have risen in India as macro fundamentals have seen some tightening. The benchmark 10-year government bond yield has risen 131bps to 7.77 per cent from 6.46 per cent. The rise in interest rates has come on the back of rising inflation, with current CPI inflation at 5 per cent, significantly higher than the decade-low of 1.5 per cent a year ago. With inflation running above the RBI’s medium-term target of 4 per cent, coupled with higher global yields amid worsening of external balance and INR depreciation, RBI raised the repo rate by 50 bps to 6.5 per cent over the past few months after a four-year hiatus.

However, the current rate-hike cycle differs from earlier instances of rate hikes as what we are seeing is the normalisation of rates from an abnormally low period of rates. Interest rates are not rising because of runaway inflation. As the RBI, along with other central banks, gradually step away from supporting markets, we are likely to see higher market volatility, tightening of financial conditions and pressure on bond yields and spreads. So in this scenario, what should an investor do?

Allocate well

First and foremost, it is imperative for an investor to get his/her asset-allocation strategy right. Market volatility has increased after several years of calm. Living with market volatility is a lot easier when you have the right asset allocation in place.

As rates are rising amid strong growth momentum, we don’t yet see interest rates at a level to impact growth, which keeps us still bullish on risky assets. Hence, both bonds and equities remain our preferred asset classes.

In our view, bond yields are attractive because:

  • RBI’s pre-emptive rate hikes, coupled with balanced inflation risk assessment, raise the bar higher for another hike in the near term,
  • Bond markets are factoring in one more rate hike by the RBI (one-year forward rate is about 50bps above the repo rate),
  • The difference between the 10-year government bond yield and the repo rate is at about 120 bps compared with a five-year average of 74bps, even after two rate hikes, and
  • Real yields (inflation adjusted) at 2.9 per cent is still high relative to other emerging markets.

We continue to prefer short-maturity bonds over medium- and long-maturity bonds on the back of liquidity support by the RBI, most negatives being priced in, and unfavourable bond demand-supply dynamics.

We also see opportunities rising in corporate bonds on swifter resolution of bad loans, deepening of the credit market, low corporate default risk, improving credit cycle and attractive valuations.

However, we remain selective because credit risk is still elevated, with bad loans still rising and stress existing in some sectors and segments. Investors with a time horizon of three years could look at accrual funds focussing on a judicious mix of credit quality while targeting a higher yield to maturity.

Equity-market fundamentals continue to improve with domestic growth outlook still robust amid rising earnings growth expectations.

Valuations are not at extreme levels yet, and domestic flows is a key support. We continue to prefer large-cap equities over mid- and small-caps as:

  • Macro fundamentals are supportive of large-cap equity outperformance as lead indicators suggest robust domestic growth ahead, amid rising interest rates,
  • Earnings comfort is greater with large-cap equities with the Nifty 12-month trailing EPS growth at 12 per cent, while the same for Nifty Midcap is negative at -17 per cent, and
  • Although mid-caps have corrected, they continue to trade at a premium of about 17 per cent to large-cap equities, significantly above a historical discount of 5 per cent to large-cap equities.

Being selective

Overall, we are bullish but selective about where we take risk (favour corporate bonds) and prefer having a greater margin of safety (favour short-maturity bonds and large-cap equities). Now is not the time to go all-in on risky assets as markets are likely to remain volatile. Our advice to investors is to ensure consistency with one’s appetite for risk and include investments that should help offset losses in more riskier assets.

The writer is MD and Head, Standard Chartered Wealth Management, India.

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