For most of 2011, interest rates were on the rise, whetting the appetite of investors for debt investments. With rate cuts expected after March, what's the outlook for the bond market?

Interest rate outlook

The RBI has clearly indicated that it will stop raising interest rates. So markets are now betting on policy rates coming down. The recent moderation in inflation and slowing economic growth have supported this view.

The markets are expecting the RBI to cut repo rates by 50 to 75 basis points over the next 12 months. The cuts are expected to begin after July but we think the cuts may not be as steep as in 2008-09 when rates fell by 4.25 percentage points over six months.

This is because India's troubles with inflation, the key metric that the apex bank is watching, may not yet be over.

First, although food and primary inflation have abated recently, manufacturing inflation has not. Pending increases in coal prices and electricity tariffs may also feed into manufacturing inflation.

Second, though global commodity prices have cooled off recently, rupee weakness has offset much of this correction for Indian importers.

Third, crude oil prices, a key inflation driver, have not corrected by much. Any oil price hikes post-election may further fuel inflation.

Time not right for gilts

Based on the expectation of rate cuts, benchmark 10-year gilt yields that hit a high of 9 per cent in November have cooled to 8.26 per cent now. But this may not be an opportune time to enter gilts for two reasons.

One, the supply of gilts is likely to rise over the next three months owing to a slippage in the fiscal deficit targets. This may pressure gilt prices and push up yields.

Debt markets early in 2011 cheered the lower borrowings announced by the government. But a fall in small saving inflows and lower disinvestment income has already led to government hiking its borrowing target by close to Rs 92,872 crore for this fiscal (a good 22 per cent more than the budgeted market borrowings).

Two, banks are today heavily invested in government bonds as the credit off-take continues to be subdued. If demand for credit increases in coming months, banks may reduce gilt investments, also pressuring prices.

These factors suggest that this may not be a good entry point into long-term gilts.

The only liquid avenue available for retail investors interested in government securities is through gilt mutual funds.

Returns on these have been quite volatile. Ten-year gilt yields have swung from 5.2 to 9.4 per cent in the last five years. In addition, because of their longer-term investments, these funds register higher capital gains or losses on their NAV based on whether interest rates fall or rise. The average returns on gilt funds over the last five years have been 6.6 per cent. Timing your entry well is quite important while investing in gilt funds.

Investors seeking safety, however, can instead get exposure to top-rated quasi government entities through some ongoing bond issues. For instance, upcoming tax free bonds of Indian Railway Finance Corporation, HUDCO and infrastructure bonds of REC, PFC and IDFC can be considered.

Interest rates on such bonds are linked to government security yields. Interest rates of close to 8 per cent for tax-free bonds are attractive for investors in the high-tax bracket.

Corporate debt better

While long-term gilts don't appear attractive now, bonds from top-rated corporates do. From here, top-rated corporate bonds may outperform gilts for two reasons.

One, as Ritesh Jain, Head of Fixed-Income at Canara Robeco says, the balance sheets of top-rated corporates are in much better shape than the government. While the government is on a borrowing spree, top Indian companies have been cutting back on their investment plans, reducing debt on their balance sheets and hoarding cash.

Any issuances by them are, therefore, likely to be quickly picked up by institutional buyers.

Two, thanks to the same cautious mood, the supply of paper from them is also not likely to be high. In fact, this appears to be the reason why since March 2011, yields on AAA rated corporate bonds have not risen as much as government security yields.

Focus on the short-term, play it safe

Agreed, corporate bonds now appear a better bet than gilts. But should investors buy short-term (1-3 years), medium-term (3-5 years) or long-term options (5 years-plus)?

Those considering these options would essentially have to take the mutual fund route, which offers all three kinds of products. The short and medium-term funds appear better bets today.

Flat yield curve

While interest rates are expected to moderate from current levels (See accompanying story on Interest rate outlook), the fall in policy rates this time around may not be as steep as in 2008-09.

Gilt and long-term income funds, which bet on 5-year-plus instruments, usually make the most capital gains from a fall in interest rates. Shorter-term funds benefit more from interest rate accruals.

This suggests that moderate falls in interest rates would make for limited gains on bond and gilt mutual funds. Investors, therefore, can continue to look at short-term bond funds.

The other big reason why short and medium-term funds appear good options is the flat yield curve. Essentially, short-term bonds (1-2 years) today offer much the same yields as long-term bonds.

Under normal circumstances the yields on short-term bonds should be lower than long-term investments, as one takes the additional risk of interest rate volatility in the long term.

This suggests potential for yields at the shorter end to come down (and bond prices go up) once the rate cuts are effected.

Dhawal Dalal, Head, Fixed-Income, DSP Blackrock Mutual Fund, suggests investing in either short-term debt funds or the dynamic bond funds to play this trend in 2012. Dynamic bond funds have flexibility to increase or decrease duration based on the prevailing interest rates.

Look beyond returns

Fund managers, however, also warn it is best to play it safe when it comes to corporate bonds.

AAA bond investments are the preferred choice. While AAA- rated bond yields may decline to close the gap with gilts, bonds that enjoy lower ratings may not see an equivalent dip in yields.

In fact, bond issues from NBFCs with credit ratings ranging from AA+ to AA-, which offered high yields last year, are now trading lower than their par value.

Highlighting the riskiness of these bonds, Canara Robeco's Ritesh Jain says, “Slowing investment activity, deteriorating currency, lack of clarity in Euro Zone and high cost of debt will continue to put pressure on sub-prime corporate balance sheets. Hence the chances of credit downgrades increase.”

This suggests that while choosing a debt fund too, investors shouldn't merely look at the returns. Portfolio risk is a key factor. Under normal circumstances, the risky portfolio may give good returns as interest receipts flow in, masking the risk.

But during periods of crisis, where corporates are facing the risk of falling interest coverage and debt refinancing woes, these funds may take a hit.

Dalal points out that given the open ended-nature of DSP's debt funds, investors can exit anytime. This means the investments have to be liquid to meet the demands of investors. Therefore, they predominantly invest in banks' certificate of deposits and AAA bonds.

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