'We Think Investors Should Move Away From Passively Run Long Duration Funds'

After reducing rates aggressively in recent times, the RBI took a pause in the recent policy meet. In an interview with BW Businessworld, Suyash Choudhary, Head - Fixed Income, IDFC Mutual Fund offers his views on the debt market in the times to come, and advises retail clients on their fund selection.

In light of the mildly hawkish tone used by the RBI in their most recent policy meet, what is your medium term outlook on interest rates? Do you foresee the scope for further rate cuts, especially if monsoons disappoint?
Suyash: In our view, most of the disinflation witnessed over the past 2 years has largely been on account of 4 underlying factors: fall in global commodity prices, fall in domestic rural wages, prudent hikes in minimum support prices (MSP), and efficient management of cereal stocks. Amongst these, global prices have recently been rising whereas rural wages seem at the point of inflection. MSP and cereal stock management are still prudent but are no longer contributing to incremental disinflation. Finally, the core components of CPI seem firmly stuck in the 5 - 5.5 per cent band. Given all of these, we think the rate cut cycle is broadly done. The key to further disinflation and sustained rate cuts rests with structural supply side measures by the government.

We expect the yield curve to continue to steepen as has been the trend over the past 9 months or so. Front end rates (1 to 5 years) should benefit from the RBI's new liquidity framework as well; whereas long end rates may be sluggish owing to lack of incremental disinflation.

Should investors lock in their money in 3 year FMP's at this time?
We think short and intermediate bond strategies focused on the 1 - 5 year segments offer the best risk versus reward pay-offs. Investors don't necessarily need FMPs to participate in such strategies.

What are the factors that a retail investor needs to consider at this stage while deciding which type of debt fund(s) to opt for? Where is this information available?
From a macro-cycle standpoint, we think investors should move away from passively run long duration funds. We don't think they provide as compulsive a risk to reward ratio as they did over the past 2 years. Active duration and short / intermediate bond strategies may offer a better trade-off. Also, credit funds should not be a mainstream exposure with investors simply because Indian markets as yet don't provide the means to hedge or manage credit risks either through secondary market liquidity or via availability of derivative instruments.

Is it worthwhile to invest in long term Gilt funds at this stage, if one has a 3-5 year horizon?
Indian rates still have a very large element of cyclicality built in; although this cyclicality may decline if we manage to sustain a low CPI and current account deficit regime over the medium term. For this reason, investors should prefer actively managed funds rather than passive long duration funds. This is especially true now, in our view, since we don't see further sustained disinflation and rate cuts from here.

What do you see as the key medium term risks to debt fund performance at this stage?
The largest durable factor affecting performance is the inability to manage risks, in our view. This could be owing to fund structure (passive duration) or market structure(for instance the illiquidity in lower rated credits and lack of hedging mechanisms).

Lastly, should retail investors with a time horizon of 1-2 years opt for arbitrage funds over debt funds, given their increased tax efficiency?
While taxation is an advantage, arbitrage funds will not hedge re-investment risks for an investor if money market rates continue to fall. For that reason, we think investors should also hold short and medium term funds.