Should you opt for bonds ahead of RBI rate cut? Here is what Harsimran Sahni of Anand Rathi Global Finance says

The US Federal Reserve recently kicked off its monetary policy easing cycle with a higher-than-expected interest rate cut of 50 basis points (bps). Now many market watchers expect that the Reserve Bank of India (RBI) will also reduce the interest rates in its next Monetary Policy Committee (MPC) meeting, scheduled to be held from October 7–9, 2024.

While bank fixed deposit (FD) returns are expected to decline following the rate cut, how can investors achieve higher returns while keeping risk levels low?

In a conversation with Business Today, Harsimran Sahni, Executive Vice President & Head of Treasury at Anand Rathi Global Finance, shared his thoughts on the impact of the rate cuts by the US fed on the Indian bond market and the Indian currency, investment opportunities in fixed income, key risks and more. Edited excerpts:

Q) How will the US Fed's rate cut impact the Indian bond market and the Indian currency?

Harsimran Sahni: On Wednesday 18 Sep 2024, Fed surprised the financial markets by cutting the rates by 50 bps to 5.00% as against the expectation of a 25 bps rate cut, furthermore, planned to cut 50 bps more in this calendar year and 100 bps in the next year and 50 bps in CY26. The US Fed rate cut significantly impacted Indian Govt Bond yields as they trended lower afterward.

Although RBI mentioned that they will not be getting influenced much by the Fed, however, there is a chance for a change in stance in the October 2024 meeting and then a possible window opening for a rate cut in the December or February MPC meeting. We expect Govt bonds yield to trend lower in coming months after RBI rate cuts.

For the currency market, the Dollar index (DXY) has weakened post-Fed rate cutting cycle which will support Rupee to strengthen against the US Dollar. We have already seen USD/INR move down to Rs. 83.50 from Rs. 84.00 during the last few weeks after the Fed rate cut.

Q) With bank FD returns expected to decline following the rate cut, how can investors achieve higher returns while keeping risk levels low?

Harsimran Sahni: Currently, FD rates are around 7.10% - 7.40% offered by PSU banks for retail investors, whereas 5-year Indian Government bonds (IGB) are trading at 6.70% yield. So, the investor can invest in 5Y IGB securities considering the possibility of rate cut by 50 bps in next quarter or two, which could help investors garner additional capital gains of around 1.5%–2.00% and improving overall returns to 8%-8.5% annually with very low risk levels.

Q) What are the key factors to consider when investing in corporate bonds?

Harsimran Sahni: The few key factors that can be considered are:

Interest Rate View: Depending upon the interest rates scenario, one should look to invest in bonds. When interest rates rise, bond prices fall and thereby leading to capital loss or vice versa. Interest rate direction is the key factors for investing in corporate bonds as when interest falls, investors can earn additional capital gains from falling interest thereby earning better returns.

Default Rate: In corporate bonds, the risk of default is much higher than the Govt. bonds.  Therefore, investors should do a credit analysis on the corporate bonds and also look at the rating from various rating agencies and invest in AAA quality bonds and if want to take further risk, then invest in higher credit risk fund via institutional routes who have better understanding of credit quality.

Spread over Govt bonds: Earlier, the spread between corporate and Govt bonds yield was around 60-70 bps. However, it has come down to 30-40 bps which is generally the average spread in the recent times. Therefore, it is ideal to invest when spread is above 50-60 bps and when spread tend to move lower, it helps investors earning additional capital gains.

Tenure:  Depending upon the interest rate view, one should ideally look to invest in a different tenure at different point of interest rate cycle to maximize their returns. Generally, in the peak of interest rate hike cycle like last year, one should invest in the longer duration bonds which rallies more ahead of rate cuts but when rate cut starts, to maximize the returns, one should switch to lower duration maturity like 3–6-year bucket which will react more to rate cuts announcement compared to longer duration.

Q) What are the key risks associated with bonds, and how can investors effectively manage them?

Harsimran Sahni: The few risks involved while investing in Govt bonds. They are:

Capital loss: The investor can incur a capital loss on the invested price if the interest rate cycle turns and hikes start to happens and the market value of the bond may decrease which could result in capital loss.

Reinvesting risk: The coupon received on invested bonds which is received on semi-annual basis, need to get invested each time, so if the interest rates have fallen, the investor may get less returns on additional investment as against previous investments.

Beating inflation: There can be times when the returns received by the bonds may be not able to beat inflation.

The few risks involved while investing in corporate bonds. They are:

Default Risk: The major risk involved with corporate bonds is that the issuing company may default on its interest payments or fail to repay the principal at the end of the bonds’ maturity and if the company’s credit rating is downgraded, the value of the bond can decrease, making it harder to sell. Therefore, one can look to debt mutual funds where they have different companies in the portfolio to avoid the concentration risk.

Liquidity Risk: Corporate bonds of small companies tend to have lessor liquidity as compared to easily traded as Govt bonds, particularly with less well-known companies. This could make it difficult to sell the bond at the desired time and price.

Sector or Company-Specific Risks: If the issuing company is in a particular sector, which is facing a few economic difficulties, this can affect the company’s ability to meet its obligations. Likewise, company-specific challenges, such as poor management, declining profitability, or bankruptcy could impact the bond’s market value.

Callable Risk: When interest rate cuts happen, the issuing company may opt to repay the bond before its maturity. This can lead to future loss of investors as when they reinvest, the return would be less than previous investments made at higher yields.
 
Q) What are your expectations for the Indian bond market and overall economy?

Harsimran Sahni: In the near time, the RBI will, too, cut rates which could lead the steepening of the interest rate curve thereby yields falling faster at the shorter end of the curve compared to longer duration bonds. As the longer-term papers’ yield has already come down significantly, so, we can expect the yield at the shorter end of the curve to fall more thereby having more attractiveness on the rates curve.

The RBI will probably cut rates by 25 bps in Dec/Feb MPC meeting thereby bring the cost of capital down and encouraging more private investment which should augur well for India's GDP and overall economy and also CPI has moderated significantly and is heading lower to RBI’s target of 4% as per inflation targeting framework, thereby RBI has enough room to act upon rates going ahead.