The pain started with the possibility of the Federal Reserve talking of a taper in May, which led to a sell-off in the rupee. This led to the Reserve Bank of India (RBI) resorting to a classic interest rate defence for the currency - resetting overnight rates higher by 300 basis points (bps) with an intent to increase the cost of carry for the rupee and hence discourage speculation. This resulted in massive yield curve inversion with the overnight funding rate being more than 150 bps higher than the long tenor government bonds.
The rules of the game were changed by new RBI Governor Raghuram Rajan as he announced a series of dollar-garnering measures. Cumulatively, these measures reversed the rupee's fortunes. However, Rajan surprised the markets by raising the repo rate, even as he moved to restore normalcy to the liquidity adjustment facility corridor by simultaneously cutting the MSF rate that resulted in normalcy in the bond market and correction in the inverted yield curve.
While activity in the bond market remained muted due to high rates, the spreads in the 10-year AAA rated bond, which hit a high of 1.9 per cent in mid-August has come down to 1.17 per cent. In the short term, bond market yields are expected to be driven more by G-sec yields. The new 10-year benchmark government bond is currently trading at 8.8 per cent, down from the recent peak of 8.96 per cent touched on December 27, 2013. The only time the 10-year yield has sustained above the nine per cent in the last decade was in July 2008 (after the Lehman crisis on the back of huge government bond supply) and, briefly in August 2013, on the back of steep currency depreciation.
Currently, the market is worried about further rate rises on the back of sticky Wholesale Price and Consumer Price indices. However, once the benign effect of better agricultural output shows on primary articles' prices and the currency depreciation pass through is complete, the momentum in inflation prints may begin to come-off, thus giving RBI some comfort to pause the rate-rise cycle. We expect interest rate cycle to moderate in the next 12-18 months.
In this context, long-term corporate bonds could prove to an attractive avenue for investments, as they will not only benefit from further spread compression but can also yield decent capital gains as the interest rate cycle reaches its peak. Current issues of tax-free bonds such as NHPC are extremely attractive for HNIs in the 30 per cent tax bracket. There are a number of upcoming issues such as National Highways Authority of India, Airports Authority of India and Indian Renewable Energy Development Agency, expected to be launched this quarter. Fixed maturity plans (FMPs) with double indexation benefit would also be an attractive investment for this client segment. In the open-ended mutual fund product segment, long-dated gilt funds and income funds could also be used to take advantage of the expected moderation of interest rates in the medium-term. Short-term money could be parked in liquid funds.
From the non/marginal taxpayer segment, CPI-based inflation bonds offer an attractive inflation hedge over the long term. High credit (AA- and above) NCD IPOs of longer tenor from reputed corporates also offer an alternate investment avenue.
To sum up, investors looking at leveraging the expected medium-term moderation of interest rates should invest in a mix of instruments such as tax-free bonds, CPI-based inflation bonds, NCDs, FMPs, and gilt funds.