The change in inflation forecast by the Reserve Bank of India (RBI) by 220 basis points in the last four months is perhaps the most striking example of the rapidly changing macro landscape that we are dealing with. What began as a consensus view of inflation being transitory and driven by temporary supply side disruptions has now turned into an acknowledgment of the stickiness in these price pressures.
That said, there is good news on the horizon. Central banks, including the RBI, have embraced the new paradigm and have clearly focused on limiting inflation by promoting growth. The government has stepped up with fiscal measures to tackle supply-side price pressures. This may not solve supply side disruptions and demand-supply mismatches in the short term, but will impact incremental demand and price pressures in the medium term as we get into a restrictive monetary policy regime.
In the Indian context, the RBI and the markets are now almost in sync both in terms of inflation and growth projections for FY2023. The market had previously underestimated the extent of these pressure points, but inflation expectations have since lowered themselves significantly. moved north of 6%. Many future rate hikes are factored into bond yields, as well as at least a portion of the additional pressure that could arise from a demand-supply mismatch in the sovereign bond space. With the RBI now in sync, the expected rate hike trajectory will be broadly in line with market expectations and for what it is worth. This means that the scope for negative surprises is reduced.
options for investors
Fixed income funds are a basket of products that offer different combinations of potential risk-reward to investors and require relevant holding periods to materialize returns. Even in the worst-case scenarios, there are extremely short end products like liquid and ultra-short duration category funds that offer a conservative option even for short durations despite limited return potential. But with less room for negative surprises, allocation to categories like ultra-short/money market/low duration funds with holding periods of 3-12 months and short term/banking and PSU/corporate bond fund categories from 18 months + perspective are more palatable from a risk-return point of view. The long end of the yield curve, which has also been meaningfully reevaluated, may still develop for some time until investors become more comfortable around the demand-supply dynamics in the G-Sec markets. We are approaching a level where absolute returns in the next 6 months can spur investments in this sector as well. Similarly, Target Maturity ETFs/Index Funds have seen significant improvement in carry (portfolio yield), and continue to deliver better return visibility on hold till maturity.
During the correct holding period, about 90% of the return in fixed income comes from carry, which has grown exponentially over the past 12 months. While the noise around higher inflation numbers and frequent rate hikes will continue, what matters from an investor’s perspective is the returns of their holding period. However, one does not expect the yield to start down-trending anytime soon, barring unforeseen macro events, what matters is the cushioning already available to handle such moves as the carry has improved. The key in this environment is not to mitigate the risk, but to identify the buffers already created to manage it.
Finally, fixed income results, barring an element of credit risk, are always driven by more than the true investment holding period, rather than short-term volatility in rates. This is especially so in markets like the current market, which have tried a lot of negative prices. Hence, focus on the right product based on your investment horizon and it should perform reasonably well in the near-to-medium term.
Amit Tripathi is the CIO-Fixed Income Investments, Nippon India MF.