In December 2020, when we wrote our Big Story on why rates will rise again (https://tinyurl.com/risingrates2023), we said that investing in floating rate bonds and locking into the shortest possible tenures in fixed deposits and debt mutual funds were the debt investor’s best bet.
This strategy was a good fit for a time when interest rates in India were scraping rock-bottom. Then, RBI had lowered its repo rate to 4 per cent owing to Covid, leading banks were offering 4 to 4.5 per cent on their fixed deposits, post office deposits offered 5.5 per cent and the NSC 6.8 per cent. The yield on the 10-year government security, the bond market benchmark, was below 6 per cent.
But the situation has changed dramatically in the last two-and-a-half years. By July 2023, RBI had hiked its repo rate by 250 basis points to 6.5 per cent. Banks have hiked fixed deposit rates to 6.5-7 per cent levels. Post office term deposit rates are at 7-7.5 per cent and the NSC offers 7.7 per cent. The yield on the 10-year gilt hovers at 7.2 per cent, after peaking at 7.5 per cent a few months ago.
So, should investors switch from floating to fixed rate instruments? To assess this, it is necessary to take a call on the rate outlook first.
MPC signals
Viewed from a historical perspective, it may look as if India’s repo rate at 6.5 per cent now, is hovering at the mid-point between its highs and lows. In the last twenty years, it has swung between 4 per cent and 8.5 per cent.
But a more realistic assessment suggests that the repo rate, after climbing 250 basis points from Covid lows, may be close to its peak in this cycle. In deciding to hike the repo rate, the Monetary Policy Committee (MPC) strikes a balance between containing inflation and helping economic growth. While India’s GDP picked up from Covid lows to register a 7.2 per cent growth in FY23, prospects for FY24 do not look overly rosy with RBI expecting a 6.5 per cent growth. Risks from El Nino and global recession worries pose challenges to the Indian economy firing on all cylinders. CPI inflation seems to be under control too, falling from 7.4 per cent in September 2022 to 4.8 per cent in June 2023. Yes, a patchy monsoon has led to recent flare-ups in rice, pulses and tomatoes, which could push up the CPI in the coming months.
But economists, including those in the MPC, believe that hikes in policy rates (which curb demand) can do little to rein in such shortage-driven bouts of food inflation. Therefore, the risk of the repo rate being hiked to deal with the current bout of inflation seems low. Last week, the MPC decided to remain in pause mode on the repo rate despite projecting that CPI inflation would average 5.4 per cent for FY24. As long as actual inflation readings do not substantially overshoot this forecast, a repo rate hike looks unlikely. General elections due next year may also nudge policymakers to stay off unpopular rate hike decisions. But with the official inflation target at 4 per cent, a rate cut may also not materialise anytime soon. This offers a long window of opportunity for debt investors to rejig their portfolios.
Investing strategies
Here are the shifts that this outlook may require in your debt portfolio.
Bonds: For investors looking to invest with longer tenures of over three years, fixed rate bonds offering high yield are a better bet than floating rate bonds. For instance, on the face of it, the GOI Floating Rate Savings Bond appears to be an attractive instrument today with its current coupon of 8.05 per cent (July-December period). But it needs to be kept in mind that this coupon is floating and may be enjoyed only for a year or two. The coupon on this bond is reset every six months at a 35-basis point spread over the NSC’s interest rate for the preceding quarter (7.7 per cent for April-June 2023).
Should the NSC rate be revised downwards a couple of years down the line, the coupon on the GOI bond would float downwards too. Over the GOI bond’s seven-year lock-in period, it is almost a certainty that the coupon will decline from current levels. Investors seeking certainty of income may therefore be better off with AAA-rated corporate bonds that today offer a fixed coupon of 7.5-7.8 per cent for 10-year tenures.
Fixed deposits: With limited upside in rates, this is also a good opportunity for investors to lock into the attractive rates on bank and NBFC FDs of a longer tenor (four-five years). Currently, AAA rated NBFCs such as Bajaj Finance and Mahindra Finance offer coupons of 8.05 per cent to 8.35 per cent for 44-month to 60-month tenures. These should be preferred over short-term FDs of upto 3 years. In the small savings menu, the five-year NSC (7.7 per cent) or the Senior Citizens Savings Scheme (8.2 per cent) should be preferred over the shorter-term options.
Debt funds: Buying debt mutual funds with longer average maturity (four years plus) gives you the opportunity to earn high interest accruals along with possible NAV appreciation, when rates start their next downcycle. Adding corporate bond funds with longer maturity should be preferred over low duration or short duration debt funds, which will see their yields dip if rates fall. The time remains good to buy five-year and 10-year constant maturity gilt funds, as opposed to money market or short term debt funds investing in treasury bills or short-term gilts.
All the above options apply only to investors who can hold on for the long term (5 years plus). For a temporary parking ground, bank FDs or short duration funds may suffice.
