GR Exclusive: Interest Rates Likely To Keep Falling In 2024; How To Invest In Debt Mutual Funds Like A Pro?

With central banks beginning the cycle of rate cuts, 2024 will almost certainly prove to be a pivotal year for the global fixed-income market. As domestic inflation starts to decline in FY25, the RBI is also anticipated to start the rate-cutting cycle in 2HCY24. IMF Chief Economist Kristalina Georgieva stated on Thursday that interest rates should continue to decline in 2024, but she also issued a cautionary note, saying that any lapse in policy would be disastrous since the last mile is "very, very tricky". During the World Economic Forum's Annual Meeting in 2024, she stated in an interview that central banks shouldn't tighten too soon as that may lead to their losing the current win. She stated that she anticipated the positive trend to last until 2024.

During the FOMC meeting in December 2023, the US Fed kept the benchmark rate within the forecast range of 5.25% to 5.5%. More significantly, they projected a 75 bps rate cut in 2024. The "Fed pivot" was well received by the markets, and the 10-year US Treasury bond ended 2023 nearly flat. The likelihood of a rate cut by the Federal Reserve in the first half of 2024, the expectation of policy continuity following the outcome of the State elections in India, and the prospective inflows from India's inclusion in the global EM bond index continue to be positive factors for Indian bonds. Global policy rates are either at or very close to their high, and by the end of 2024, it is anticipated that they will have plummeted.

Since the US Federal Reserve has begun to reduce interest rates, experts anticipate that interest rates will drop in India as well. To find out how investors may invest in debt mutual funds like pros in today's marketplace, let's get the advice of our industry experts.

How Market Is Likely To Respond To Any Anticipated Changes In Policy Stance And Rate-cut Cycle Well In Advance?

2024 in all probabilities will prove to be a Pivotal year for the Global Fixed Income market as Central banks start the rate-cut cycle. RBI is also expected to embark upon the rate cut cycle in 2HCY24 as domestic inflation moderates in FY25. Rate cuts will be preceded by the change in stance of "Withdrawal of accommodation" to Neutral.

Additionally, India is in a sweet spot as domestic fiscal demand - supply dynamics are looking favorable with expected fiscal consolidation by ~40-50 bps in FY25 and ~USD 25 bn inflow in Indian G-Sec due to the inclusion in JP Morgan global debt index. Healthy Fx reserve at ~USD 625 bn provides meaningful cover to absorb global volatilities. Risk factors to watch-out for are global energy prices & supply side disruptions led by geo-political risk which can change the expected course of inflation moderation, according to Vikas Garg - Head of Fixed Income, Invesco Mutual fund.

Overall, risk-reward has turned favorable at the current juncture with benign fundamental & elevated yields across the curve. While the near-term volatility may remain high mainly coming from global factors, any large upside on yields is expected to be limited on the back of India's inclusion in global bond indices and healthy buying at current absolute levels, Vikas Garg stated.

How Policy Rates Are Expected To End Lower By End-2024?

According to Vikrant Mehta, Head -Fixed Income, ITI Asset Management Limited, the US Fed expectedly held the benchmark rate in the 5.25% - 5.5% target range in the FOMC meeting in December 2023, and importantly projected 75 bps (100 bps = 1.0%) of rate cuts in 2024. Furthermore, though the Fed decided to continue with the pace of quantitative tightening (QT), the FOMC minutes indicated discussions on when to flag the balance sheet change. Markets have welcomed the "Fed pivot" and the 10-year US Treasury bonds closed largely unchanged for 2023. The nearly 1.0% fall from the 2023 peak in the last 2 months of the year seems to have left less room for error and puts the market at significant odds with the Fed's policy rate forecast trajectory.

The RBI expectedly kept the repo rate as well as the policy stance unchanged at the December 2023 MPC meeting. The tone of the MPC was balanced with the focus on the need to sustain the disinflation path to ensure a durable alignment of CPI to the 4.0% inflation target being partly offset by cautioning the risk of over-tightening, especially when large structural changes, geopolitical and geo-economic shifts are taking place. Since November 2023 we have increased duration across portfolios as the global environment became less hostile and anticipated the Fed to acknowledge the same. We moderately further added duration in December 2023 and expect our portfolios to maintain higher maturity over the coming months as compared to the past year, stated Vikrant Mehta.

Prospects of a Fed rate cut in 1H CY2024, expected policy continuity at the Centre post India's State elections results and potential inflows from India's inclusion in the global EM bond index remain tailwinds for Indian bonds. We expect any sharp increase in yields (not a base case) to be bought into and expect rates to trade lower into FY2025. Long-maturity bonds are expected to find favour with long-term investors over the coming months and we see some merit in taking advantage of this seasonality. Global policy rates are at peak levels or near peak levels and policy rates are expected to end lower by end-2024. The current environment seems suitable for duration products such as Dynamic Bond funds and Banking & PSU Debt funds which are well positioned to take advantage of a falling interest rate cycle and can deliver superior risk-adjusted returns as compared to non-market linked fixed rate products, Vikrant Mehta further added.

We expect the inflation to continue to trend down towards the target of about 4% and the macro-economic outlook for bond markets is likely to get incrementally better by Q3 of the FY25. With the US Fed starting to cut rates, we expect interest rates to fall in India too. In our opinion investors may invest in duration funds with prospects of decent mark-to-market gains along with high accrual, Parijat Agrawal, head -fixed income, Union Asset Management Company Pvt. Ltd expressed his view on interest rate cut.

How Debt Funds Are Attractive This Year For Risk-Averse Investors?

Harsh Gahlaut, CEO, FinEdge said that debt funds continue to be attractive this year for risk-averse investors and are expected to deliver inflation-beating returns. We expect interest rates to plateau from the current peak before slowly cooling off towards the end of the year. There, however, will be a lot of legroom to remain invested in debt-oriented investments keeping tight liquidity and inflation in mind.

From an asset allocation perspective, if the return of capital is of paramount importance and the investment goal horizon is less than two years, then debt as an asset class cannot be replaced with equities.

Within debt Mutual funds, it would make sense to reduce exposure towards GILT funds slowly, which have a strong inverse relationship with interest rate movement, and reallocate investments towards corporate bond funds. Another alternative to consider would be arbitrage funds as they also bring in tax efficiency without compromising on risk to capital, especially if the investment duration is between 1 to 2 years.

Trends To Monitor Before Investing In Debt Mutual Funds

According to VLA Ambala, SEBI Registered Research Analyst and Co-Founder of Stock Market Today- SMT, amid expectations for interest rate reductions in Q3, individuals keen on investing in debt mutual funds must develop a strategic approach to reassessment. The predicted shift in monetary policy towards lower rates would favor medium to long-term debt instruments. Typically, these instruments tend to appreciate in value as rates fall, offering both capital gains and interest income. Similarly, shifting portfolio allocations towards government securities and high-quality corporate bonds can be beneficial due to their lower credit risk.

However, managing the duration of investments is key to maximizing their benefits. This is because longer-duration bonds gain more from declining rates, so extending the average duration of debt portfolios aligns well with the expected rate cuts. Monitoring the credit quality within portfolios is also crucial, as higher-rated bonds may provide better returns with lower risk in a low-rate environment.

The prevailing economic indicators suggest a decline in benchmark 10-year bond yields below 7% soon, reflecting market anticipation of a future rate-cutting cycle. Liquidity in the banking system, currently tight due to high government surplus, is expected to ease with increased government spending in the next few months. Additionally, macroeconomic factors like fiscal deficit, which stood at 50.70% until November, and a Current Account Deficit of 1% of GDP in Q2 should be considered to build a robust reallocation strategy.

Global economic trends and major central bank policies are also crucial, impacting capital flows and exchange rates, thereby influencing domestic interest rates and bond markets. Additionally, monitoring inflation trends is essential, as it directly affects the real returns from fixed-income investments. Remembering these will allow investors to build an investment strategy that helps optimize returns while managing risk in a dynamic economic landscape, explained VLA Ambala, SEBI Registered Research Analyst and Co-Founder of Stock Market Today- SMT.

What Debt Investors Should Do?

Permitting risk appetite, it is a prudent time to go long on duration with increased allocation toward funds like Gilt fund, Dynamic bond fund, Medium duration fund, Corporate bond fund, Banking & PSU Funds etc which can provide participation in 5 yr+ maturity segment. One should not wait to see the start of actual rate-cut cycle. Markets, being forward-looking will react much in advance to the expected policy stance change followed by a rate cut cycle thereby upfronting the returns through spread compression of G-sec over policy repo rate, said Vikas Garg.

Manish Maryada, Co-founder and CEO of Fello said that investors are advised to broaden their investment mix by including short to medium-term debt funds, especially during periods of declining interest rates. This strategy aids in managing risk and potentially increasing returns. Effective selection of funds and staying abreast of market trends are crucial for optimizing the performance of debt mutual funds in such situations.

Atul Garg, Founder, FinEzzy stated that with a likely decline in interest rates in the coming quarters, strategically aligning debt mutual fund investments towards long-term income and gilt funds of medium to high duration could be a wise move. Such funds are well-suited to capitalize on the inverse correlation between bond prices and interest rates, making them an attractive option for those seeking growth in a falling rate environment.

Harsh Goela Co-Founder of Goela School of Finance said, "Bond prices and interest rates have an inverse relationship. When interest rates fall, bond prices tend to rise, and vice versa. In a falling interest rate scenario, investors should prefer short-term and medium-term debt funds. These funds are less sensitive to interest rate changes compared to long-term funds, reducing the risk of capital losses. Longer-duration bonds are more sensitive to interest rate changes than shorter-duration bonds Some mutual funds have the flexibility to adjust their portfolio duration based on market conditions. Dynamic bond funds may be considered for their ability to adapt to changing interest rate scenarios."

Suman Bannerjee, CIO, Hedonova recommends repositioning debt mutual funds in anticipation of an expected downturn in interest rates during Q3. With the current stage of the interest rate cycle approaching its zenith and minimal prospects for further Reserve Bank of India rate increments, investing in debt funds becomes a prudent choice. As the interest rate cycle transitions downward over the next 2-4 years, capital appreciation in net asset value is foreseen, contributing to enhanced returns.

However, prudent considerations must be given to inherent risks, including uncertainties in the rate cycle trajectory due to inflation or economic concerns and possible credit quality fluctuations. Hedonova underscores the importance of astute fund management and advocates the selection of high-quality debt instruments such as government securities and AAA-rated papers to mitigate associated risks.

What Should Be Your Allocation Towards Debt Mutual Funds?

According to Amar Ranu, Head - Investment Products & Insights, Anand Rathi Shares and Stock Brokers, the global market is sitting at the peak of policy rate and the policymakers are unanimous on easing policy rates to fuel the growth which has been fading of late. On the other hand, the RBI's scope of rate cuts would be limited (~50-75 bps over FY25) unlike global developed peers. However, other factors like twin deficits (fiscal deficit and current account deficit) look quite comfortable. Additionally, the upcoming inclusion in a large global bond index will see increased traction from FPIs which will likely constitute net incremental demand for Indian bonds. We have already seen an inflow of Rs 55k crs in the last 3 months.

Considering the above-mentioned factors, we feel interest rate is headed for a downward trajectory in the near future and it is prudent to play a portion of debt portfolio through duration depending upon the risk profile. Higher the risk profile, higher is the allocation towards long-duration debt mutual funds.

According to Dr. Jagriti Arora, Assistant Professor, Finance and Accounting, Great Lakes Institute of Management, Gurgaon, at the time when interest rates fall, debt funds offer a very creative opportunity for all those who wish to earn better-than-average returns from fixed-income securities. This happens due to the inverse relation between interest rates and the price of debt securities. Thus, a fall in interest rates pushes up the NAVs of debt funds. On a deeper note, investors should also consider diversifying across different maturities and types of debt instruments. Shorter duration funds may be less sensitive to interest rate changes while long-term funds could benefit more from falling yields. Moreover, one must hold a mix of high-rate Corporate bonds and/or government securities for an efficient risk-return payoff matrix.

Disclaimer

The recommendations made above are by market analysts and are not advised by either the author, nor Greynium Information Technologies. The author, nor the brokerage firm nor Greynium would be liable for any losses caused as a result of decisions based on this write-up. Goodreturns.in advises users to consult with certified experts before making any investment decision.