'Expect RBI to cut rates by at least 50 basis points'

A certified chartered accountant and a company secretary, Deepak Agrawal began his career in research and dealing with Kotak Mutual Fund in 2002, and then moved to fund management in 2006. Now, with over two decades of experience at the AMC, he is the Chief Investment Officer-Debt, overseeing 12 schemes.

In a recent interview with Value Research, Agrawal discussed the likelihood of interest rate cuts in the US and India, noting, "India is likely to cut rates in the second half of this year and over the next year." He also elaborates on his strategy for positioning Kotak Mahindra Dynamic Bond Fund to benefit from such expected rate cuts and shares his debt fund recommendations for investors. Below is the edited transcript.

What drew you to fixed income instead of equity?

I am a Chartered Accountant (CA). After passing the intermediate exams, one can continue with audit work or pursue industrial training in a manufacturing or service industry. Since I also aspired to be in investment banking, fund management, or even the treasury of a corporate house, I took up Kotak Mutual Fund as an assignment during my industrial training. Meanwhile, I was pursuing a master's degree in business administration (MBA), and a position in the fund management team within the fixed-income department was available. In the early 2000s, there were limited opportunities in the fixed-income sector, so I seized the chance to join the fixed-income team at a fund house. I can proudly say that I have seen the fixed income market right from the nascent stage, and we grew together.

Over time, I learned the tricks of the trade and understood the nuances of the market with real-time experiences. As they say, handling crisis is the best teacher; over the years, I've seen multiple crises, like the global financial crisis, the currency crisis triggered by the famous taper tantrum of the Fed and the Covid-19 pandemic crisis. All these crises had different implications. My entry into fixed income was accidental, but the journey has been exciting and rewarding.

What's your core investment strategy when selecting different debt instruments?

After having a clear outlook on rates based on macroeconomic fundamentals, we first look at the yield curve and evaluate, try to read what the market is pricing, and then decide which segment to invest in across the yield curve. Therefore, based on this perspective, we determine whether to invest for a longer or shorter duration.

Next, we base our decision on the relative spread that exists between, for example, a government security, a state government security, and a corporate bond. Depending on the relative attractiveness of the spread and our outlook for the future, we will select either government securities or corporate bonds for allocation. Similarly, within the corporate bond space, we determine whether to invest in AAA-rated papers or to go even lower down the curve based on the spread. Overall, it depends on how much risk is priced in and how much is available for the new investor, and we deploy accordingly.

The Kotak Dynamic Bond Fund has delivered 10.3 per cent returns in the past year, partly because it allows you to adjust holdings based on the interest rate environment. With the fund's average maturity of 21.60 years (13.53 years in the category), are you anticipating rate cuts? Could having such a high maturity lead to more volatility in the fund?

Fed Chairman Jerome Powell recently stated that the time has come to cut interest rates. Now, we will have to wait and see the job data. If the job data is weak, we may witness a rate cut of 50 basis points in the US. Currently, real rates in the US are close to 250-275 basis points, and with inflation coming down, the Fed is likely to bring the real rate down to 150 basis points, which indicates an interest rate cut of 100-125 basis points.

In addition, next year, inflation is likely to be lower by 50 basis points. So, we believe that until December 2025, there will be cumulative cuts of close to 150-175 basis points in the US.

We also believe that the RBI will likely cut rates in the second half of this year and over the next year. The RBI will cut rates by 50 basis points in our best-case scenario. There's a chance that if there is further global easing, the RBI may also cut rates by 75 basis points. Therefore, we are operating under the assumption of rate cuts.

Additionally, the supply of government securities (G-Sec) in the domestic market has remained relatively stable over the past three years. However, we have observed increased demand for G-sec, especially from insurance companies and banks. In addition, our inclusion in the JP Morgan index in the last financial year is expected to bring in close to $25-30 billion, and later, we may see flows due to India's inclusion in the Bloomberg Emerging Market Bonds Index.

Therefore, given the expectations of potential rate cuts, it is likely that the demand for government bonds will continue to be robust. These combined factors lead us to believe that long-term rates will likely trend lower. We have been running our funds at high durations to capitalise on this trend.

Could having such a high maturity lead to more volatility in the fund?

The golden rule of investing is to align your fund choices with your investment horizon and objectives. Long-term investors should generally opt for long-term funds to mitigate reinvestment risk. However, in the current environment, where the long-term outlook is positive, it's sensible to stick with long-term funds. For those who prefer lower volatility or have a shorter investment horizon, medium-term or short-duration funds, such as a corporate bond, banking, or PSU fund, are suitable. These funds currently average around three years in duration. With potential rate cuts, which might lead to a steeper yield curve, a 50-basis point reduction in interest rates could potentially result in approximately 1 per cent in capital gains for these funds, making them an attractive option in the present market conditions.

To put it in perspective, let's consider a short-duration fund with a yield to maturity of approximately 7.5 per cent. This implies that the gross return for this category could be as high as 8.5 per cent. Let's say a medium-term fund has a yield to maturity of nearly 8.25 per cent. The gross return could be 9-9.5 per cent, assuming a 50-basis point rate cut and a close to 30-basis point drop in the yield.

Typically, we suggest investors should select funds based on their investment horizon. Investors should choose a dynamic fund with at least a one-year investment horizon. Yes, volatility would be there, but we believe that at the current juncture, it does make sense to run this kind of duration.

Since the announcement of sovereign bonds being included in the JP Morgan Emerging Market Bond Index, 10-year government bond yields have fallen and are now near the year's lowest. With an inclusion rate of 1 per cent per month over the next seven months, do you expect yields to slide further, or is this already factored into bond prices?

As I have mentioned, the domestic demand-supply is quite favourable. Once we have clear visibility of banks' liquidity coverage ratios (LCR), we will see incremental demand for G-Sec anywhere between Rs 2-4 lakh crore starting in April 2025. However, if we assume that the incremental demand for G-Sec will be Rs 3 lakh crore and factor in the flows from JP Morgan and the rate cuts that will occur by then, the demand will surpass the supply quite favourably. However, some part of the news is already in the prices, and we have seen yields easing already.

Let's take an example where yields were at 7.10-7.15 levels last year, and now they are at 6.85-6.90 levels, indicating a significant decrease of nearly 30 basis points. In addition to the favourable demand for government securities, there is a possibility of rating upgrades and rate reductions of 50-75 basis points in India and 150-175 basis points in US markets. It is likely that 10-year yields, currently at 6.85-6.90 levels, could come down to 6.25-6.50 levels in the next six to 12 months.

Given the current scenario, which debt fund category would you recommend to retail investors for their fixed-income allocation?

In the current scenario, I would suggest two schemes to the investors.

One is our medium-term fund, which has a current duration of approximately 3.5 years and a yield to maturity (YTM) of approximately 8.25 per cent. Investors may consider this category, given the likelihood of a lower rate trend.

Second, they can also look at long-duration funds like gilt or even dynamic funds, which have a duration of close to 10 to 11 years. Based on our view of interest rates, which will likely come down with rate cuts from central banks and the favourable demand-supply dynamics of government securities, investors can choose either of the schemes.

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