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Govt and AAA-rated bonds, target maturity and short-term funds will shine in 2023

Government bond yields rises significantly over the past 12 months and may peak out soon. But India’s real yields outperform most emerging markets. This creates a short-term opportunity and prospect of making healthy medium-term returns

February 07, 2023 / 09:05 AM IST
Fixed income is an attractive asset class

Fixed income is an attractive asset class

Bonds had a challenging 2022 with the widely used bond benchmark - Crisil Composite Bond Index - up only by about 3 percent, underperforming other major asset classes - gold (about 14 percent), equities (6 percent) and cash (5 percent).

Bond yields rose to multi-year highs in 2022, as the RBI raised policy rates by 225 bps to 6.25 percent. The RBI along with other major global central banks tried to burnish its inflation-fighting credentials by signalling an aggressive pace of rate hikes, indicating its willingness to sacrifice growth to sustainably bring down inflation from multi-decade highs, leading to a spike in domestic and global bond yields. Bond gains were muted across major bond mutual fund categories with gilt funds, long-term duration funds and medium-term duration funds lagging other bond categories.

The worst may be behind for bond markets

Over the course of 2022, continued upward shifts in the market’s expectation of central banks’ terminal or peak policy rates given persistent and elevated inflationary pressures, was a key headwind for bonds. The global macroeconomic backdrop for 2023 is likely to be challenging. One of the fastest Fed interest rate hiking cycles on record makes a US economic recession very likely. We also expect a recession in Europe due to the energy price shock. An economic slowdown should help inflation cool significantly but not all the way back to the 2 percent target of the US Fed.

In our assessment, India’s growth-inflation dynamics is stable and better than its peers. The post-pandemic economic recovery cycle remains strong amid supportive government policies and a pick-up in investments. Further, the likely broadening of the economic recovery to the rural economy and service sectors is a strong tailwind.

Inflation is likely to trend lower on easing food and commodity prices, fading pent-up demand pressures and lagged impact of monetary policy tightening. Overall, as the monetary policy rate cycle peaks amid receding inflationary pressures in the second half of the year, bond yields could see downward pressure supporting bond prices.

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Can 2023 be the year of bonds?

On the whole, 2023 offers a very different backdrop for bond investors as the risk-reward for bonds has improved with an attractive yield on offer and most of the incremental rate-hikes likely priced in by markets. Further, we see increasing value in bonds, especially relative to equities.

Indian government bond yields have risen significantly over the past 12 months and are likely to peak out in the coming months and range closer to 7.5 percent-7.75 percent (now 7.35 percent) as central banks move closer to the end of the rate tightening cycle. In addition, Indian bonds’ real yields (net of inflation) are higher compared to their Emerging Market (EM) peers. Overall, this presents both a short-term tactical opportunity as well as the prospect of making healthy medium-term returns.

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Nevertheless, it is important for investors to be wary of the risks. Three factors for bonds remain unfavourable: 1) fiscal deficit is likely to remain high over the medium term, 2) worsening government bond supply balance, given the high supply of government bonds amid a lack of support from the RBI and muted demand by institutional investors especially foreign investors, 3) persistent high inflation and policy rate hikes by the RBI and the US Fed, are likely to exert upward pressure on bond yields at least in the near-term.

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Attractive opportunities within bonds

Overall, we believe investors today can achieve an attractive income in many bond segments by just taking relatively modest interest rate and credit default risks. Government and high-quality (AAA) corporate bonds are attractive as they have seen a significant widening of spreads. These bonds offer a high carry and better risk-reward given the likelihood of tight financial conditions persisting in 2023.

We like short-maturity bonds as a flattening yield curve has improved the yield carry for them relative to medium and long-maturity bonds and given their lower sensitivity to rising interest rates. The sharp rise in short-term yields in 2022 suggests that the bond market has priced in a significant amount of policy tightening.

Selective bond strategies like (1) Target Maturity strategies of medium duration that are likely to benefit from higher carry, lower interest rate risk and falling residual maturity, (2) floating-rate strategies that can help investors to offset inflation and duration risk, (3) dynamic bond strategies that provide investors better accruals and help actively manage duration risk are also likely to do well.

However, we are still in a rising interest rate environment and thus having a diversified bond allocation with a mixture of the above strategies is key to managing interest rate risk. Investors should remain cautious about increasing duration given its higher sensitivity to rising rates.

Vinay Joseph is the Chief Investment Strategist, Standard Chartered Wealth, India
first published: Feb 7, 2023 08:38 am