FMPs, CPoFs good bets in benign interest rate scenario

As rates cool off, investments made in debt instruments will appreciate and see gains

For some time now market participants have held the view that the interest rate cycle has peaked or is nearing its peak, given our inflation trajectory. However, given the current circumstances of India’s macro-economic factors, the Reserve Bank of India may find it difficult to cut rates in the immediate future.

The stickiness of inflation (especially CPI and food inflation) and the prospects of higher government borrowings and deficit concerns as well as worries over global commodity prices will continue to weigh on the domestic market. Nonetheless, given the need to kickstart our economy, the market is of the opinion that interest rates need to soften and it is only the timing of the future cuts that is a point of discussion.

In the context of India’s long-term economic growth estimates and long-term inflation trajectory, our medium to long-term view has an undertone of bullishness and we expect interest rates to soften in the next two quarters.

Why rates will cool off? The internal situation is becoming healthier in the last one month. The concern over monsoon has been removed by the latest guidance from the Indian Meteorological Department (IMD). International crude prices have come down substantially, leading to a strong possibility of diesel price decontrol following a sharp drop of under-recoveries. The balance-of-payment situation has improved following a reduction in trade deficit and there is a likelihood that inflation will come down in future due to better monsoon and higher base effect.

The only concerns are the geopolitical problems in Iraq, Israel and Ukraine. These issues also may not go out of control since the governments there are aware of the effects on the global economy.

The other concern is over interest rates going up in the US sooner than later. This has been discounted largely and there may be a shorter-term reaction when it happens. As rates cool off, investments made in debt instruments will appreciate and see gains. The extent of the gains will depend on a variety of factors, including the nature and credit quality of the security and residual life of the instrument. It is noteworthy that incremental investments made in times of lower interest rates earn less in terms of yields and/or coupons, thereby affecting the future profitability of the portfolio.

Given this economic backdrop, it is a good time for investors with a medium- to long-term investment horizon of, say, beyond six months to invest in debt instruments and products, which can take advantage of the softening of interest rates.

As mentioned earlier, our economy has slowed down. But given the bleak global conditions, we may continue to outperform other developed and developing markets. We also hold that the interest rate cycle has peaked or is near peak. Given our long-term economic growth estimates and our long-term inflation trajectory, the medium to long-term view has an undertone of bullishness. In such market conditions, investors having a medium- to long-term investment horizon can go in for duration products, such as dynamic bond funds, medium-term bond funds and PSU bond funds. Investors may also look to lock money into higher interest rates through FMPs and capital protection oriented funds (CPoFs). Debt-oriented hybrid funds such as MIPs may also find favour in the coming year.

(The writer is the chief investment officer of LIC Nomura Mutual Fund)

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