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The Rajan regime makes fixed-income unpredictable

Between a strong-willed RBI governor and a fraught external environment, fixed income fund investors should get used to a new level of unpredictability

Last week, RBI Governor Rajan sprang a surprise when he raised interest rates. Talking heads everywhere were convinced that he would keep rates static, with hardly anyone allowing an outside possibility that he would raise rates. In fact the fringe suggesting a rate cut was actually larger than the one suggesting a rate hike. As it happened, Rajan came out all guns blazing on inflation. However, he went a step further. He completely reframed the conventional growth (low rate) vs inflation fighting (high rates) debate by emphasising that low inflation was a pre-condition for growth to come back.

The point he made--which I felt wasn't adequately appreciated--that it is impossible to lower rates in the face of high inflation, not the least because it's unfair to savers. First, inflation must be brought into control, then rates will fall, and then growth will follow. It's not possible for these three steps to occur out of this sequence. Between the new-found focus on consumer inflation on one hand, and the worry about savers getting a fair rate on the other, the concerns of the common man (I won't use the now politically loaded 'AA' phrase) is central to this RBI in a way that it has never been before.

But anyhow, he impact on inflation, growth etc will work out as they will. At the end of the day, the government has to do a lot and we'll see how and what happens if and when we get a real government. However, there's another aspect to the RBI's new modus operandi, and that's something that affects investors directly. Events of the last few months have shown investors in fixed income mutual funds will have to get used to a new kind of environment, one where surprises are not only possible but even likely.

For a long time--in fact, since the time in the early 2000s when fixed income fund investing came off age in India, it has been a fairly dull and predictable activity. There have been some surprises--like in 2008, obviously--but by and large fixed income investing has been a placid activity. The central bank's rate changes--which are the immediate drivers behind returns--have been almost always predictable. Almost always, the consensus of the talking head economists has been correct. The central bank has done what the conventional wisdom of the day has been. There may have been some mild surprises on the magnitude of the action, but hardly ever on the direction.

Those days are gone. Firstly, since the middle of the last year, when Ben Bernanke first set off the tapering bomb, fixed-income investors have had an unwelcome amount of excitement and thrills. While the whole tapering affair is an external shock that will play out in some unpredictable way, the subsequent months have seen investors trying to contend with the Raghuram Rajan way of thinking and working. So far, the motivation and the instincts of the new RBI have been hard for the bond markets to fathom. This is unlikely to change in the near future.

While bond traders will look after themselves as best they can, fixed-income mutual fund investors need to take a close look at how well they have been sticking to the basic rules of how they should act and invest. It's very much back to the basics time. And back to the basics means aligning your investment horizon with the maturity of the fund that you choose. In the new uncertain environment, investing for a few days or weeks in funds which are holding bonds with years of residual maturity can be disastrous. In fact, as the events of last July showed, even liquid funds--which are the safest--can make losses for a day or two. This is an unprecedented phenomena for Indian investors.

Like equity and other types of investing, a new element of risk has entered fixed income investing. It may be small compared to equity but within the context, it is just as significant--and it's not going to go away.




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