'Entering debt market now can still yield decent returns'

Although the RBI's recent rate cuts have raised doubts over the appeal of debt investments, Aditya Pagaria, Senior Fund Manager (Fixed Income) at Axis Mutual Fund, maintains an optimistic outlook. He is of the view that an attractive yield curve, low projected inflation and compelling real interest rates make fixed income a promising opportunity over the next year.

Right now, Pagaria manages 21 schemes at Axis, including the Axis Banking & PSU Debt Fund and Axis Treasury Advantage Fund, which have been rated four stars by Value Research.

In this interview, Pagaria takes us through his investment strategy and how it enables his funds to stay agile in a turbulent market. He also discusses why this could be a good time for investors to lock in higher yields, how retail investors should approach fixed-income investing and the factors that drove the strong performance of the Axis Floater Fund.

With the RBI cutting interest rates to spur growth amid rising global yields, how do you see the Indian debt market? Is it stable, choppy or full of opportunities?

I see it as a good opportunity for fixed-income investors. Rate hikes or cut cycles typically last one to one-and-a-half years, sometimes even two. We've had a stable rate environment for the past year and a half, but in the last three months, we've seen two rate cuts, signalling the start of a rate-cutting cycle.

Investors who entered the market six to eight months ago have earned double-digit returns from duration funds. But the story is not over yet. The Monetary Policy Committee is now more accommodative and responsive to market feedback, suggesting the rate-cut cycle isn't over. So, returns can be made from fixed-income investments as well. While global factors like volatile US 10-year yields, a strengthening dollar or rising crude prices could pose challenges, we're quite optimistic about the fixed-income outlook for now.

Some might feel they've missed the bus since yields rise as rates fall, boosting debt instrument returns. What's your advice, and do you expect more rate cuts? If so, what quantum?

The market is pricing in roughly 50 basis points of additional rate cuts in this cycle. The RBI has injected significant liquidity in the last four months of around Rs 8.5 lakh crore through measures like open market operations, forex swaps and long-term repos, which we haven't seen in a long time. This indicates that investors haven't missed the bus. Parts of the yield curve remain attractive, so entering now can still yield decent returns over the next year.

Is this an opportunity to lock in higher yields?

Yes, definitely. The repo rate is currently 6 per cent, and overnight rates are around 5.75 per cent due to liquidity measures by the RBI. Yet, corporate bonds are available at 7-7.25 per cent while government securities (G-secs) are close to 6.5 per cent. With the RBI projecting inflation at 4 per cent for this financial year, the real rates are compelling. There's a significant carry for investors, making fixed income an attractive option for this year.

How do you pick debt instruments, and what's your core strategy?

Selecting debt instruments depends on the fund's mandate and SEBI's guidelines for different fixed-income funds. We take a macroeconomic view, considering factors like inflation, the global economy, growth trends and banking liquidity. About 80-85 per cent of the portfolio is built based on this view, forming the core portfolio. The remaining 10-15 per cent is used opportunistically to generate alpha. For instance, when credit spreads expand, or there's a dislocation in the yield curve, we seize those opportunities to enhance returns. The core portfolio remains stable, while the tactical portion adapts to market conditions.

Is this process the same across all your funds?

Yes, the macroeconomic view is consistent across all funds. Based on this view, we build the core portfolio, which accounts for 80-85 per cent of the allocation. The rest depends on the specific fund mandate and market opportunities.

You mentioned global risks and RBI rate cuts. If the RBI pauses rate cuts or global conditions worsen, how are you positioning your portfolios to stay nimble?

Across our debt funds, 80-85 per cent of the portfolio consists of sovereign and AAA-rated assets, which are highly liquid. This allows us to easily adjust if market conditions change, such as reducing duration by selling these assets. If yields harden due to an unfortunate event, our liquid holdings enable us to churn the portfolio and adapt swiftly.

Fixed income can feel daunting for retail investors. What's your advice for choosing and sticking with debt funds in today's dynamic market?

Retail penetration in debt mutual funds is low in India, as many prefer traditional instruments like bank fixed deposits (FDs) or insurance. However, debt funds can offer superior liquidity and diversification. Unlike traditional instruments, where exiting early incurs penalties, debt funds provide next-day liquidity. At Axis, our philosophy is SLR, which is short for safety, liquidity and returns in that order.

How do you balance this with risks from rising global yields impacting domestic bond prices?

Rising global yields are a concern. A few years ago, the differential between Indian and US 10-year yields was 350 basis points; now, it's closer to 200 basis points. Markets are jittery about potential inflation spikes or issues like the current tariff tantrum. However, the RBI's accommodative stance and liquidity measures provide a cushion. Our portfolios maintain high liquidity, with 80-85 per cent in sovereign and AAA-rated assets. If yields rise unexpectedly, we can churn the portfolio, reduce duration and adapt to market changes.

Your Axis Floater Fund delivered 13 per cent returns over the past year. Floater funds are said to work well when interest rates rise. What drove the fund's strong performance?

We positioned the Axis Floater Fund to perform in both rising and falling rate environments. When we believed rates had peaked, we shifted from floating-rate to fixed-rate bonds, increasing the fund's maturity to 8-10 years in the last year. This captured the rally in duration funds during the rate-cut phase. We also used synthetic options to maintain the fund's floating-rate mandate, allowing us to benefit from both scenarios and driving performance.

How do you evaluate an issuer's creditworthiness for fixed-income securities, and how does this differ from analysing equities?

Credit evaluation is critical, especially given past credit crises. We focus on three primary factors: the quality of the promoter and management, the company's leverage and the sectoral outlook. We also assess the company's ability to generate cash flows and the promoter's flexibility to inject capital during distress. Unlike equity analysis, fixed-income investing, especially in lower-rated securities, involves covenants to be built into term sheets, requiring a minimum promoter holding, rating thresholds or leverage caps. If these are breached, the company has to repay the bond, adding a layer of protection unique to fixed income.

In equities, flexi-cap funds offer a mix of large, mid and small caps. Is there a debt fund category that's an all-weather option for long-term investment with flexible exit options?

SEBI has launched a new Fund of Fund (FoF) category, i.e. Income plus Arbitrage FoF. This is an interesting category for investors to consider. It requires a prescribed minimum allocation to arbitrage funds, with up to 65 per cent in debt funds and functions as an FoF. This can provide stable returns and tax efficiency for investors with a horizon of two years or more, making it ideal for those seeking a balanced, long-term debt product.

In the current economic environment, how should investors split money between equities, debt and other asset classes? What role do debt funds play in a balanced portfolio?

Asset allocation depends on individual factors like goals, age and risk appetite, so there's no 'one-size-fits-all' approach. Fixed income has the potential to act as a cushion in a portfolio, whereas equities have the potential to deliver higher returns in good years but may be flat or negative in others. Debt funds aim to provide stability to investors' portfolios.

You've been in the industry for about 18 years and have seen events like the 2008 Global Financial Crisis, the 2013 Taper Tantrum, the 2018 credit crisis and the 2020 Covid crisis. What were the key lessons learned from these events?

I don't view these events as a crisis but as opportunities for investors to leverage. Investors who maintained discipline made money during these periods in their investments. This means sticking to a consistent asset allocation strategy. For example, when equity markets perform well, investors tend to increase their equity allocation, whereas it's probably wise to book profits in equity and move to other asset classes. Today, gold has outperformed, delivering nearly 40 per cent returns in the last year, so investors can use this opportunity to diversify from gold to equities, which have seen sharp corrections. Investors can use these opportunities to rebalance asset allocation, maintain disciplined investing through systematic investment plans (SIPs) and not stop them during a crisis.

Also read: The Indian debt market has shown extreme resilience: Abhishek Bisen of Kotak Mahindra AMC