The global central banks have kickstarted a rate hike cycle given the inflation and global uncertainty, meanwhile, the bond yields have been on the rise. The combined effect has led to the revival of interest in the fixed income market. The uncertainty around inflation, central bank actions and global economic conditions continues to keep investors on edge.
In an e-mail interview with ET Now’s Rakshita Madan, Kotak Mutual Fund’s Fixed Income head, Abhishek Bisen, explains why debt markets may be offering a compelling opportunity, how investors should approach asset allocation in the current environment, and why higher yields could prove rewarding for those willing to look beyond short-term volatility.
Here are the edited excerpts:
1. With the RBI tightening its monetary policy to contain inflation, how do you see the Indian debt market evolving? What opportunities and risks should investors watch out for in the current interest rate environment?
We are navigating an exceptionally uncertain environment characterized by volatility, uncertainty, complexity and ambiguity. While domestic macro fundamentals remain important, global factors such as financial conditions, geopolitical developments, oil prices and shifts in risk sentiment are increasingly influencing Indian bond markets through their impact on the currency and capital flows.
Our assessment suggests that with 1-year forward inflation around 5.25% and GDP growth near 7%, the traditional macro framework points to a terminal repo rate of roughly 6.0-6.25%. However, bond yields appear to be discounting much higher terminal rate. This indicates that markets may be pricing in a more aggressive tightening cycle than what may ultimately be delivered.
The key risk is that tight global financial conditions, elevated oil prices and continued pressure on the INR could keep yields elevated for longer. At the same time, these factors have created opportunities. Yields across the curve remain attractive, and the substantial flattening of the yield curve offers compelling carry at the short end and attractive lock-in opportunities at the long end. Investors who remain disciplined and align duration with their investment horizon can potentially benefit from this environment.
2. Given the current interest rate and inflation outlook, how should investors approach asset allocation between fixed income, equities and other asset classes? Should they increase their allocation to debt at this stage?
Asset allocation should be driven primarily by investment objectives and risk tolerance rather than short-term market forecasts. However, after a prolonged period where fixed income offered relatively limited value, debt as an asset class has become considerably more attractive.
Current bond yields imply a more aggressive policy path than our estimate of the eventual terminal rate. This has created an environment where investors can earn attractive carry while maintaining relatively moderate risk. For many investors, this may justify gradually increasing strategic allocations to fixed income, especially where portfolios have become heavily skewed towards equities following the strong rally in risk assets.
We believe debt can once again play its traditional role of providing income, diversification and portfolio stability. Short- and medium-duration strategies offer attractive risk-adjusted carry, while long-duration exposures may provide additional upside if yields eventually adjust lower. That said, debt should complement rather than replace equities, as long-term wealth creation still requires exposure to growth assets.
3. What are the key factors guiding your debt investment strategy? How do you evaluate credit quality, duration risk and yield opportunities while selecting debt instruments?
Our investment framework is built around three pillars: credit quality, duration management and relative value.
On credit, we maintain a strong focus on business fundamentals, balance-sheet strength, cash-flow visibility, management quality and the issuer’s ability to withstand economic stress. Given the uncertain global backdrop, we continue to favour high-quality issuers where risk-adjusted returns remain compelling.
On duration, our positioning is driven by a combination of macroeconomic assessments, liquidity conditions and market pricing. Currently, bond markets appear to be discounting a higher terminal policy rate than our fundamental assessment suggests. This creates opportunities to selectively add duration where valuations are attractive.
On yield opportunities, we focus heavily on relative value across segments of the curve. Liquidity tightening has led to significant spread widening in certain parts of the market. For example, segments of the AAA PSU curve that historically traded at tighter spreads have widened meaningfully, providing attractive opportunities for investors who can look through near-term volatility. We seek to capture these dislocations while maintaining a strong emphasis on portfolio liquidity and risk management.
4. High bond yields around the globe have been driving investors. Do you think it’s a trap? Higher yields also mean lower bond prices. How should investors decide?
Higher yields are not necessarily a trap. In fact, for long-term investors, higher yields are often the starting point for stronger future fixed-income returns.
It is true that rising yields result in mark-to-market losses in the short term. However, investors should distinguish between short-term price volatility and long-term return potential. The yield at which a bond is purchased remains one of the strongest predictors of long-term returns from fixed income.
Today, investors are being compensated with substantially higher yields than they were a few years ago. The key question is not whether bond prices may fluctuate in the near term, but whether current yields adequately compensate investors for inflation, policy uncertainty and credit risk.
Investors with shorter time horizons may prefer the front end of the curve where carry remains attractive and duration risk is lower. Investors with longer horizons can consider locking in elevated yields, particularly in segments where spreads have widened beyond historical norms. Rather than trying to perfectly time interest-rate cycles, investors should focus on matching duration to their investment horizon.
5. The US Fed, RBI and other global central banks have kickstarted the rate-hike cycle. What is your view on where rates are headed? Will higher rates alone solve inflation when much of the problem stems from supply-demand imbalances?
Monetary policy remains an important tool for anchoring inflation expectations, but interest rates alone cannot solve inflation when a significant part of the pressure originates from supply-side factors.
Food prices, energy prices, geopolitical disruptions, shipping bottlenecks and commodity-market imbalances are largely outside the direct control of central banks. Higher policy rates can moderate demand, tighten financial conditions and prevent inflation expectations from becoming entrenched, but they are less effective in addressing supply shortages.
Our view is that markets may currently be pricing a higher terminal rate than what economic fundamentals justify. With forward inflation around 5.25% and growth near 7%, our framework points toward a terminal repo rate closer to 6.0-6.25%, whereas bond markets appear to be implying a substantially higher level. If this assessment proves correct, current yields could eventually adjust lower as markets reassess the likely trajectory of policy rates.
Until then, investors should expect periods of volatility, particularly as global developments continue to influence currency markets, liquidity conditions and bond yields. In such an environment, maintaining portfolio flexibility and focusing on valuation rather than market timing becomes increasingly important.