Debt - The Forgotten Asset Class

Historically, Indian investors have always been attracted to debt as an investment category in the form of fixed deposits. However, in recent years, investors embraced equity for their investments. In 2021 and 2022, equity markets saw an unprecedented rally and entered into an overvalued zone by historical parameters. The second half of 2022 saw heightened interest in debt as central banks around the world, including the Reserve Bank of India (RBI) in India, raised interest rates to reign in inflation. As a result, debt came into the limelight after a long gap thanks to the rising attractiveness of the asset class.

Since the pandemic, interest rates in India were brought down to very low levels, owing to which debt became an uninteresting asset class. The year 2022 saw a sharp rise in global inflation which many believed was transient in nature. But in reality, it turned out too sticky, owing to which global central banks were forced to raise policy rates sharply and roll back quantitative easing. This caused a sharp reversal in capital flows, a spike in global bond yields and a sharp correction in global stocks and bonds. In effect, the return potential of Debt Funds improved considerably. The real rates have turned positive in the Indian fixed-income space. Hence, it is time for investors to lock in funds at higher yields. Currently, the government bonds across tenures are trading between 6 to 7.5 per cent which is above the expected consumer price index (CPI) inflation for 2023. 

Since April 2022, the RBI raised rates from 4 per cent to 6.25 per cent i.e. by a cumulative 225 basis points (bps) to tackle inflation and drained liquidity by almost ₹7 trillion. Going forward, the central bank could raise the repo rate one more time to 6.5 per cent if required and then there could be a pause in the near term. The RBI may continue to sound hawkish till core inflation starts easing.

Another aspect is that over the past decade, due to quantitative easing, corporate India could easily borrow at very low rates (close to zero) globally. Now that is no longer the case. So, it is very likely that they will be borrowing locally. When debt demand from corporates and banks rises amidst a tightening liquidity environment, debt as an asset class is better placed than equity.

What should an Investor Do?
To begin with, fixed income as an asset class moves in cycles. So there will be times when interest rates increase or decrease. Because of the cyclical nature, the better way to look at prospective returns is to look at prevailing YTMs which are in an attractive zone now. Today, there is a better opportunity to generate risk-adjusted returns in debt today compared to the past three years. 

Investors can use debt mutual funds for their debt allocation in a portfolio. A debt fund, depending on the sub-category, typically invests in corporate bonds, debentures, government securities (G-sec), Treasury bills (T-bills), Commercial Papers (CPs), Certificates of Deposit (CDs), and other debt and money market securities. The primary objective of a debt fund is to benefit from interest income and offer downside protection to the portfolio. 

Among the various offerings, investors can consider investments with a shorter duration as the one- to two-year portion of the curve looks fairly priced. The other category an investor may consider is the dynamic bond fund category. This category of debt funds stays relevant across all interest rate scenarios. This is because the fund manager has the flexibility to allocate investments across the 1-10-year duration. This offers immense flexibility to the fund manager to manage durations irrespective of the interest rate movements. For instance, when interest rates weaken, dynamic bond funds invest in longer-duration bonds to ensure higher yields. On the other hand, if interest rates are expected upward, the fund tends to lower its duration by investing in shorter-duration bonds. 

Investors can also consider target maturity funds over some of the traditional non-mutual fund fixed-income options. If held for more than three years, investors get the benefit of indexation, which enhances the post-tax returns, especially for those in higher tax brackets. The 3-5-year maturity plans look to be better placed than very long maturity plans.

The writer is CEO, Valab Investments. ■ Email : info@valabinvestments.in