Are debt markets now offering better opportunities?

One of the pillars of prudent financial planning is asset allocation and it is always advisable to have a portion of your investments in fixed income instruments, which balances your long-term financial goals with your risk appetite.

Post Covid, global equity markets did extremely well and one of the reasons was pumping in liquidity by central banks and record fiscal stimulus by governments. Adequate liquidity and other factors such as fear of a slowing economy, depressed lending rates, which when combined with rising equity markets and inflation, make the case for fixed income as an asset diversification strategy weak. But we think the tide is changing, and bet on higher returns from debt over the next three-four years that may beat even the broader index (Nifty) returns.

macroeconomic outlook

For the best returns, one needs to enter the market when interest rates are at their peak and exit when the cycle is at or near bottom. In our view, we are already at the apex of the interest rate tightening cycle and expect the rate cut cycle to begin in the current year (CY24). Globally, both growth and inflation are being downgraded. According to the Reserve Bank of India (RBI), India’s domestic growth is expected to decelerate from 6.8% in FY23 to 6.2% in FY24, with CPI inflation declining from 6.7% in FY23 to 5.3% in FY24.

Therefore, we think most central bankers are on the tightening end of their monetary policy, which is also evident as the US 10-year yield is trading near 3.75% versus the fed funds rate of 4.75% (upper bound) Is. A cut of 25 basis points (bps) is expected this year and a cut of 125 bps in CY24. At home, we expect the RBI to hold on longer and keep the repo rate at 6.50% (outside the possibility of a hike to 6.75%).

This represents an interesting case for investors of debt mutual fund schemes to lock-in a better rate and earn capital gains. If one assumes that the RBI will cut rates by 100-125 bps over the next three years, then this would add 100-120 bps to the yield for 10-year tenor paper (from 7.7% to ~6.7% for corporate bonds/state growth). There will be a drop of bps. loan, or SDL). By doing so, investors would approach a risk-free three-year holding period annual return of ~10%, which is 2.3% capital gains and 7.70% accumulation (the modified duration for the 10-year bond is 6.66, a 100 bps 10 Going forward in years the bond would increase in value by 6.66, making for an annual capital gain of 2.2% over three years).

cheap valuation

The Indian equity market is currently trading at a price-to-earnings (PE) multiple of 20.7, which correlates to an earnings yield of 4.83% (1/PE ratio), while the 10-year AAA-rated corporate debt/SDL doing business. 7.70%. Assuming similar taxation for three year debt funds and equity (with 5% indexation benefit in debt funds), even if one pays 20% premium to Indian equity, since India is a growing economy, still Debt looks cheaper than equity. ,

Historically, we have seen that the three year average return on investment in Nifty 50 when the PE is in the range of 20-22 is 8% and above 22, it drops to 4%. Hence, not only are debt at cheaper valuations as compared to Nifty 50, but the risk reward ratio is also favourable. The risk, as measured by standard deviation, is lower in GSEC AAA Debt Fund. The standard deviation of GSec AAA Debt Fund is 3%, compared to 12% for Nifty 50.

So after considering the inherent risk in equities, risk/reward wise, it makes a strong case for increasing your allocation to debt at current valuations. Markets are unpredictable, and considering the current scenario this could be a good bet.

When the interest rate cycle starts to soften, which we expect to happen in the next two years, then one can reduce credit risk in favor of other asset classes.

Piyush Garg is the Chief Investment Officer of ICICI Securities