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Fund Managers Divided on Interest Rate Outlook

The biggest trigger for the bond party to end could be RBI itself, which is increasingly concerned with interest rates sustaining at current levels.

The unprecedented bull-run in the bond markets has baffled investors and fund managers alike. With bond funds churning out returns by the minute, both investors and fund houses are having a gala time. For asset management companies, the current bull-run couldn't have come at a more opportune time since it has ensured steady inflows even as equity markets continue to be in doldrums.

Yet, with yields on bonds at historic lows, the million-dollar question is - Are these gains sustainable or is the rally going to peter out? Can investors continue to expect super returns in the coming months?

Value Research spoke to some leading bond fund managers to get their views on interest rate outlook.

Suresh Soni, Fund Manager, Kothari Pioneer Income Builder Account

On Interest Rate Outlook
The surfeit of liquidity has resulted in a long and strong rally in the bond markets. Over the short term, we could see a mild correction that is inevitable after such a strong and sustained rally over the last few months. Going forward, in face of the continuing weakness in the domestic economy, there is a natural inclination for the policy makers to ease the interest rates. This, combined with the fact that the Government has completed over 54% of its borrowing requirement and the forex reserves remain comfortable, should result in the interest rates to rule easy.

On Sustainability of the Rally
No rally in financial markets continues indefinitely, but given the current indicators we are confident that barring a mild correction and any extenuating incidents the bond markets should continue to rally in the medium term

Your Strategy in the Current Market
Given the positive sentiment in the markets, we have been increasing our allocation to liquid bonds so that we can change the maturity profile in a few days in case of a trend reversal. While there are no major concerns for the bond markets, we will still be cautious and avoid going overboard inspite of the exuberance in the markets.

Triggers that can Hit Sentiment
Fiscal deficit is an important factor. The other factors that could impact the markets are –

1.Rupee movement: Given the US dollar's rise against major world currencies, Rupee could be overvalued by about 4% in real terms. The concern for the debt markets would be - any sharp depreciation in the Rupee within a short period of time instead of the normal gradual depreciation.
2. FII flows: We are closely watching the FII flows in light of UTI's decision to freeze sale/repurchase.
3. Oil Prices: This is another factor that would impact the fiscal deficit and any increased tension in the middle east could result in higher crude oil prices.

Shailendra Jhingan, Fund Manager, Birla Income Plus

On Interest Rate Outlook
The rally is essentially due to aggressive buying by PSU banks, which seem to be parking their surplus liquidity into gilts. Part of the reason for buying long bonds previously was that there was hardly any other asset available in the market. But the yield curve continues to become steeper and that is a definite indication that the market is getting jittery about the overall interest rate structure and hence aggressively buying only short-term assets. I think the yields have definitely bottomed out and there are risks in the July-September quarter that could start impacting the interest rates.

On Sustainability of the Rally
I think liquidity will be good in the banking system and banks might keep on buying long term gilts. But a majority of the funds have been indicating returns in the region of 8-9% going forward. I don't think funds should get too much money now.

Your Strategy in the Current Market
In the current scenario, a cautious policy is the best way out. We have raised cash levels to near 10%. We would like to maintain it at that level and could raise it further in the near term if the market keeps going up the way it is moving now. The average maturity that was 5.2 years in May-end was brought down to 4.6 and would now be at 4.4 years. Cash funds look to be the best alternatives with only 1 per cent lower expected returns at zero price risk.

Triggers that can hit Sentiment
First, average inflation rate won't go below 5%. In October, one can expect another oil price hike of average 10-15% to wipe out the pool deficit. The second is that the rupee would have to adjust lower and that could impact the sentiment as it is still overvalued by 3%. Thirdly, there will be additional supply of paper to the tune of Rs 25,000-30,000 crore that could affect the outlook. The biggest trigger for the party to end would be RBI itself that would be increasingly concerned with interest rates sustaining at the current level with an errant government not able to check its borrowing plans.

Rajiv Anand, Fund Manager, Grindlays Super Saver Income Fund

On Interest Rate Outlook
Interest rates look stable to lower over this quarter.

On Sustainability of the Rally
We are bound to see some correction in the near term but any fall in prices will only be seen as a buying opportunity by the market.

Your Strategy in the Current Market
Interest rates are being driven down by the huge liquidity in the system. There is little demand for money from corporates. We will continue to run our duration at current levels (around 60 months) until we see a trigger to push interest rates up.

Triggers that can Hit Sentiment
First, RBI may act if it feels that the fall in the yield curve has been over done. Two, a serious fall in the rupee can spoil the sentiment. Last but not the least, a serious up tick in inflation levels is also a concern.