What should bond investors do in today’s market?

Globally, the Russian-Ukrainian war and domestically, the budget and monetary policy outlook are creating uncertainties. Due to the shutdowns that began two years ago, the national macroeconomy is in trouble. But the economy was weak even before we hit the pandemic. As a result, the three-year compound annual growth rate (CAGR) of real GDP was just over 1% for the first nine months of this fiscal year. This weak growth has been accompanied by relatively high inflation which, for the past two years, has averaged close to 6%, a situation close to stagflation. It is therefore understandable that policy, both fiscal and monetary, seems to be geared towards reviving growth.

Fiscal policy could be an appropriate tool to push real growth upwards. Monetary policy, on the other hand, affects nominal growth. Keeping inflation high gives a sense of growth, but runs the real risk of entrenching high inflation expectations. As a result, market expectations for future interest rate developments have risen sharply in recent months.

Added to the complex domestic situation is the war in Europe. Extreme price increases (in some cases doubling or more) of several commodities in recent days could disrupt our economy, as we are a net importer of commodities. Gasoline and diesel prices need to adjust, and perhaps food prices too. The result is a sharp weakening of the rupee to an all-time low against the dollar.

The short-term concern relates to the rise in commodity prices and its impact on inflation. However, a war is unnecessary destruction and, in the medium term, it is more likely to turn out to be deflationary than inflationary. The impact on both points will be limited if it is a short-lived conflict as opposed to a long-lasting crisis. Assuming the invasion ends quickly, we should expect to see some normalcy in commodities soon. We should expect short-term volatility, but the focus will return to domestic macros in the months ahead.

As inflation remains elevated and with some upside risk from currency depreciation and commodity prices, we should expect the Reserve Bank of India to eventually start raising interest rates. The large government borrowing program will also start to affect bond yields as the market struggles to digest the bond supply. We would like to be defensive in this environment, preferring a lower duration.

With the return to growth, the macroeconomic environment for credit (ie non-AAA bonds) should improve. In our view, this segment is already one of the best performing segments thanks to higher yields and shorter duration. We expect this to continue throughout the rate cycle.

Investors should look to funds with a portfolio duration that is less than the intended holding period. Duration approximates interest rate sensitivity or “revaluation” duration. In a rising interest rate scenario, if the holding period is greater than the duration, the effect of reinvestment (i.e. bond maturity reinvested in new bond yields) dominates the mark-to-market effect (i.e. the fall in value due to rising rates).

For a short-term investor, suitable segments may be overnight, liquid, money market funds and very short-term debt funds. Investors with a medium term horizon (say 6-24 months) can consider low duration, floating and short term segments. Investors with a time horizon longer than 3 years should consider allocating to longer duration schemes such as target maturity funds, but also consider taking on some credit risk through credit risk schemes as well as other plans that have an active allocation to non-AAA bonds.

A Sivakumar is a manager at Fixed Income, Axis Mutual Fund.

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Carol M. Barragan