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AFTER a year of global economic turmoil, the euro zone debt crisis and continuous rate hikes by the Reserve Bank of India to curb surging inflation, the dust seems to be settling a bit, allowing a brief respite while we plot our way for the year ahead.
Though recent data indicate some improvement in industrial production, housing activity and consumer spending in the US, the global situation is not expected to improve quickly, as the probability of below-par growth in the US and recession in the euro zone is fairly high.
The domestic economy, too, is facing headwinds from high inflation, high interest rates, anaemic investment and slow pace of market friendly reforms. Inflation, which has been at 9.5 per cent for quite a while, is showing signs of softening with both primary and manufacturing inflation readings falling consistently over the past couple of weeks, on account of a high base effect, good monsoon and the impact of past rate hikes. We expect the rates to remain on hold for some time before RBI starts cutting them from the start of the next financial year as inflation comes within its comfort zone.
GDP estimates are down from 8.5 per cent to around 7.5 per cent, while other macro-economic parameters such as the IIP and purchasing managers index indicate that industrial activity in a country is showing a very weak trend.
The industry will continue to be under pressure on higher interest rates, high inflation, and tight liquidity, which will translate into muted growth in the coming quarters.
So, where do we see opportunities in the next year? Macroeconomic conditions have firmly placed the spotlight on fixed income instruments with a medium to long duration.
Yields across the curve have been witnessing an upward movement over the past one year, mainly on account of higher inflation and RBI's monetary steps to curb inflation. At the moment, the flat yield curve offers a lot of value at the short to medium end of the yield curve on expectations of steepening. The 10-year Gsec benchmark has risen from a low of around 8 per cent to a high of 9 per cent and is hovering around the 8.80 per cent level.
GOI Secs are trading at their three-year high level, making them an attractive investment option. In th light of the above, we expect yields to peak out in the near future if RBI pauses on rat hikes. Persistent tight liquidity will prompt RBI to take steps for further (OMO) buy back of GOI Secs and/or CRR cut. Weak economic growth may impact the government's revenue going for ward, which will increase fiscal deficit leading to addition al supply of government papers to fund deficit. Such additional supply in GOI Sec might restrict an immediate sharp fall in yields, but at the same time increased demand due to buyback of GOI Secs in open market operations, increased FII limit and higher GOI Sec holdings by commercial banks will give the much required support to GSec yields and help improve the liquidity situation.
There is good enough demand in the short to medium tenure bonds of companies from both global and domestic investors in the light of very high running yields, moderating rate hike expectations and limited supply of bonds by good rated companies.
As spread widens between AAA-rated companies and Gsec over a period of time, we expect allocations to shift in favour on long dated corporate bonds so as to take benefit of any contraction in spreads and also high running yield on investments.
While we may see some volatility in the near term, the present shape of the yield curve does indicate that two three year bonds would benefit with yield curve steepening by rolling down the yield curve. From an investment perspective, duration funds such as dynamic bond funds, income and gilt schemes are suitable for investors with an investment horizon of at least one year and some appetite for risk and volatility as high bond fund yields at present offer a good opportunity of capital appreciation as yields start falling.
Investors with lesser appetite for risk (volatility of returns) can consider short term funds and medium to long-term FMPs, as one can expect higher gross yields, low volatility and stable returns form a moderate duration bet.
All in all, the time is ripe for investors to start adding duration to their portfolios in sync with their risk appetite.
Dynamic bond funds, income and gilt schemes are suitable for investors to invest for a year or so Investors with lesser appetite for risk can think of short-term funds and medium-term FMPs
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