Bet on bond funds, keep an eye on RBI
Dec 30 2013
The appointment of Raghuram Rajan as the new RBI governor was welcomed by industry with much fanfare. There were hopes that the industry would be a beneficiary of benign interest rates thus fuelling a pickup in industrial growth. Much as everyone, including the RBI governor, desired such a scenario, that was not to be. Blame it on inflation.
RBI’s comfort zone with respect to wholesale price index (WPI) was stated as 5 per cent. After flattering experts with a sub-5 per cent WPI print for three months in succession, the WPI deceived to rise sharply from July onwards ending at 7.5 per cent in November. Similarly, the CPI hardened to 11.24 per cent in November.
Two factors conspired to put inflation at a point where an interest rate cut could not be defended. First was food. Contrary to expectations, food prices haven’t exactly seen the benefit of good monsoons. Structural impediments continue to haunt the system keeping food prices sticky at higher levels.
To cite an example, vegetable prices appreciated by 35 per cent, 46 per cent and 63 per cent (year-on-year) respectively, in September, October and November. The rupee was the other big worry of 2013, which made it difficult for RBI to toy with the idea of lowering rates. Initial talk of the US Fed taper in May led to a strong outflow of portfolio money from debt markets, pulling the rupee down to near-Rs 69 level against the US dollar. The bloating current account deficit (CAD) presented another problem, curtailing any flexibility on interest rates.
The yoyo-like situation over 2013 with respect to inflation took a toll on the bond market. The year began with the 10-year G-sec yield hovering at 8.05 per cent level – going as low as 7.12 per cent when inflation was at a 42-month low in May. But as inflation reared its head, yields began hardening going as high as 8.96 per cent at the time of writing this note. Obviously investors saw some gains over January–May, when yields were softening. Post that period, it has been a struggle for long-term bond funds.
Is the economy on the mend?
It may well be! The bad news, at least most of it, has placed the macroeconomic situation at the rock bottom. So the only way for the economy is up.
Food prices will at some stage be a beneficiary of good monsoons, as structural inefficiencies are ironed out. Vegetable prices have already seen a sharp fall in December. The rupee is much more stable, while not exactly going strong, than it was in August and this is despite the Fed tapering becoming a reality. The current account deficit is a lot more manageable at 1.2 per cent of GDP over the July–September quarter from 5 per cent during the April-June quarter. Of course, it will take more than import curbs on gold to keep the CAD at this level. But with crude price stabilising and the rupee inching towards Rs 60 level, this could become a reality.
It is hoped that all these factors will cumulatively reflect in the macroeconomic fundamentals, particularly inflation – both wholesale and retail – to make the central bank more willing to consider a rate cut. RBI is already doing its bit – contrary to expectations it did not hike rates in December despite the worrisome data in the hope that inflation will finally fall.
When that happens and rates are lowered, the debt market will be a major beneficiary. Yields are likely to trend lower and this will reflect in higher bond prices. In such a scenario, existing investors will see a rise in NAVs of their bond fund investments. While we all want to see this scenario, remember much depends on the data. So keep your fingers crossed for 2014.