If you want to make higher returns from bonds, there are two routes open to you. You take on credit risk by buying lower-rated bonds for higher yields. Or you take on duration risk by buying bonds with long maturity and hoping for interest rates to decline. When market interest rates fall, prices of long-duration bonds appreciate sharply.

In the past year, taking duration risk has worked out great for investors. As of October 23, 2024, long-duration debt funds sported a one-year return of 12.8 per cent, gilt funds with 10-year constant maturity delivered 10.5 per cent and plain gilt funds (which also held long-dated government securities) delivered 10.2 per cent. Can you still buy long-duration and gilt funds for similar returns?

MPC actions

In India, the Monetary Policy Committee (MPC), steered by the Reserve Bank of India (RBI), influences interest rate direction by controlling the cost of short-term money and liquidity available to banks. After raising its policy rates from 4 per cent in April 2022 to 6.5 per cent in March 2023, the MPC has been on hold for the last 18 months. While markets have been expecting rate cuts from September when the US Federal Reserve eased rates, the MPC has been holding on to rates citing inflation which has remained above its 4 per cent target.

CPI inflation after moderating to 3.6 per cent and 3.65 per cent in July and August, spiked to 5.49 per cent in September. The RBI’s forecasts expect it to average 4.5 per cent in FY25. RBI officials have been saying at various forums that food inflation was turning out to be sticky and that it would be unwise to lower rates before inflation aligned ‘durably’ with the 4 per cent target. This has given rise to doubts about when and if MPC will get around to cutting rates. In previous rate cycles, India’s repo rates peaked out at 8 per cent. This time around, they are at just 6.5 per cent. Therefore, there’s a possibility that the rate cut cycle will turn out to be shallow, as well.

This uncertainty has led to bond yields firming up slightly in the market during the past month. The one-year Government Security (G-Sec) is up from 6.6 per cent to 6.76 per cent and the 10-year from 6.73 per cent to 6.93 per cent.

Inflation outlook

With the MPC hitching its wagon to inflation, CPI readings in the coming months will decide whether policy rate cuts will materialise. If we break down CPI, it is the food component which has kept it elevated. Between November 2023 and June 2024, the food element of CPI hovered at 8.3-9.5 per cent, while non-food inflation was well below 4 per cent. A moderation in food prices took down the CPI in July and August, but their rebound has seen September CPI inflation spike again.

Prospects of a global as well as domestic slowdown have been pressuring prices of industrial commodities ranging from metals to crude oil in recent months. Therefore, it is agricultural output which holds the key to a moderation in CPI. There is good news on this front. The recent South-West monsoon ended with 8 per cent above normal rains and kharif acreage is above last year’s levels. Unseasonal post-monsoon rains, while disrupting market arrivals of crops in September/October, have lifted reservoir storage. This points to good rabi prospects. A moderation in food inflation, therefore, appears likely by next year. This may prompt MPC to soften its stance on rates.

Fed moves

Though the RBI likes to clarify that its rate actions are independent of any foreign influence, central banks in emerging economies cannot ignore rate moves in the developed world especially the US, in setting their rates.

The US economy, after throwing up a string of strong jobs data until June 2024, suddenly showed weakening numbers in July and August, resurrecting recession fears. This prompted the US Federal Reserve to slash its federal funds target rate by 50 basis points to 4.75-5 per cent in its September meeting. Jobs data, however, have strengthened in September, leading to uncertainty about whether the Fed will go back into pause mode or go for a further 25 basis point cut. This has caused US (10-year) treasury yields to spike up from 3.6 per cent levels in September to 4.2 per cent now.

If the Fed refrains from cuts in its November meeting, that will give MPC headroom to hang on to rates. If it eases rates by another 25 basis points, it would pressure on MPC to lower rates.

Foreign flows

The main reason why emerging market central banks are forced to toe the US Fed line on the direction of rates, is that their rate differentials with the US affect dollar flows into their bond markets. When markets such as India offer higher rates and a favourable currency outlook relative to US rates, foreign capital gushes into bonds. When the rate differential shrinks or the rupee looks likely to depreciate, money rushes out.

Earlier, the external influence on Indian bond markets was muted by the RBI having strict limits in place on foreign investments in G-Secs and bonds. But in the last five years, the RBI has partly relaxed these controls to make some G-Secs freely accessible to foreign investors.

This has led to Indian G-Secs getting higher weights in global bond indices, opening the doors wider to foreign flows. JP Morgan GBI-EM Index was the first big global index provider to include Indian G-Secs with a 10 per cent weight starting June 2024. Indian bond markets attracted $13 billion in inflows between July 2023 and May 2024 the year before the inclusion. Between June and October 2024, they attracted about $6.3 billion. Following JP Morgan, Bloomberg and FTSE Russell have also announced that they will add Indian G-Secs to their indices in 2025.

While these additions will likely increase foreign flows into Indian bonds when conditions are conducive (high rate differentials with US, strong rupee), they will also lead to bigger outflows when conditions turn unfavourable. With US yields firming up, Indian G-Secs have seen some outflows, pushing up Indian G-Sec yields.

Rising foreign flows will result in a stronger correlation between Indian and US rates. We must brace for more volatile flows into G-Secs and more two-way moves in market yields based on US market action. But at the same time, the higher correlation also makes it tough for the MPC to move in a different direction from the US Fed.

Overall, the above factors suggest that interest rates have the potential to decline further from here. But this may not be a linear move and can occur in fits and starts. This will reflect in the returns on long-duration debt and gilt funds. Investors with a horizon of three years plus with appetite for such volatility can consider them.

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