fixed income investing

With interest rates stabilising and inflation unlikely to drive further monetary easing, investors may want to shift focus to shorter-maturity corporate bonds.

Shriram Ramanathan, CIO–Fixed Income at HSBC Mutual Fund, believes the two- to three-year corporate bond segment currently offers the “best bang for your buck,” combining attractive yields with lower duration risk.

In a recent conversation, he explained why widening spreads and stable rate conditions make this segment a sweet spot for fixed income portfolios. Edited Excerpts –

Kshitij Anand: And yes, with inflation coming in at 2.1%, do you see there is room for further rate cuts as well? And yes, we are in a wait-and-watch mode. The RBI has already front-loaded, we would say, for the year 100 basis points. But yes, could there be another rate cut in the offing?

Shriram ramanathan: See, as far as a rate cut is concerned, where we are today, the RBI governor has been fairly clear and, in some ways, you could argue maybe a bit too clear, because it takes away the hope, excitement, and expectations angle of it. That is where the communications part comes into play. But he has been fairly transparent in saying, “Hey, monetary policy has done its bit. It takes time. Now, we have to wait for it to seep through the economy.”

Kshitij Anand: The transmission has to happen, yes.

Shriram Ramanathan: Exactly. And now, for a further rate cut, it really comes down to three things broadly. The first one is obviously CPI. Like you pointed out, CPI has already been fairly below the RBI’s earlier projections. There was a huge markdown that they had to do in this particular policy, and the upcoming number is also going to be fairly lower, as per our expectations. So CPI, to a large extent, has already been pre-empted by the RBI through the markdowns they have done in the forecast. I do not think CPI will be the reason for them to go more aggressive with, let us say, further rate cuts.

The second factor is growth. And like I alluded to earlier, as and when any growth-negative impacts start becoming clearer—let us say the tariffs become crystallised and there is indeed an impact on the export side or even on our domestic economy—if there is a slowdown and if indeed the 6.5% growth estimate of the RBI turns out to be overoptimistic and needs to be marked down to, let us say, 6.1% or 6.2%, that is one reason why the RBI will start looking at whether more action is required.Third, and importantly, is the US Fed’s action. That is the other thing that has been changing over the last one month. Clearly, markets are now pricing in a September rate cut, more than two rate cuts by the end of this calendar year, and another three to follow next year. That is now driving a lot of other emerging market bond markets as well, because as and when the Fed starts moving, it opens up space for a lot of other EM central banks. The interest rate differentials start widening again, which gives more space and opportunity for EM central banks to act.So, out of the three factors, inflation is unlikely to be the reason for us to embark on any further rate cuts, but growth and US action are two things we are keeping an eye on. We do think that once the Fed starts cutting in September, somewhere in Q4 of this calendar year, the RBI will probably have a little bit more space to maybe cut once—or at most twice—though once is more likely. But yes, that would be almost the end of its arsenal as far as rate cuts are concerned. I do think that space might open up, but that really requires the growth downside to crystallise.

Kshitij Anand: Now, we have discussed rate cuts and how central banks are moving, both in India and the US. So just from an investor’s perspective, do you think corporate bond funds, especially with up to five years’ duration, look attractive now? What are your views on that as well?

Shriram ramanathan: No, I think that is a good question, because so far what has really happened over the last one year is that, broadly, interest rates have been moving lower. Duration funds have obviously had their time in the sun and were delivering good returns.

But over the last two months, we have seen— which is typical of any rate-cutting cycle— that towards the bottom of a rate-cutting cycle, rates tend to pre-empt the last few cuts. The longer-end yields make their bottom probably before the last rate cut itself, and that is what we have seen this time around as well.

We saw the 10-year bottom out at 6.17% in May, prior to the 50 basis points cut in June. Since then, we have been heading slightly higher.

So, the duration play is a lot more tactical now. There is no secular, structural move lower in longer-end rates anymore, which is why corporate bonds start looking more attractive.

Once you start drilling down into corporate bonds themselves, I would say the underlying space to look at is probably two- to three-year corporate bonds, because that is where you actually get the best bang for your buck.

Yields there are now close to 6.70%—as of now 6.70% to 6.75% for a two-year corporate bond—which is the same as a 12- to 13-year government bond.

So, you do not take too much maturity or duration risk, but you still end up getting a fairly attractive yield.

Spreads there are close to 80 basis points, the widest we have seen in quite some time—over the last four to five years.

These used to be as low as 25-30 basis points about a year to a year and a half back. That is the second reason why corporate bonds in that space are attractive.

Now, to your question of which fund category makes the most sense, I would say it is probably the short-duration category, which is actually best targeted towards slightly lower maturity, with less exposure to government bonds and more to the two- to three-year corporate bonds—rather than the corporate bond fund category you refer to. In general, if you look at the industry, I think short-duration funds are better positioned in this segment going forward.

Otherwise, you can pick and choose a few corporate bond funds. For example, the HSBC Corporate Bond Fund is specifically positioned in the two- to three-year corporate bond space and has kept the duration fairly low. That is another space I would say is good to look at.

So, to your question, it is good to look at short-duration funds or pick and choose a few corporate bond funds with lower maturity and duration and wider spreads—not so much in the five-year duration space you refer to—because that becomes a bit too long, and there is going to be a lot of supply over the coming few quarters in that segment, which will keep those yields high, or maybe push them higher still.

The two- to three-year corporate bond space is extremely good, keeps the risk low, and gives you a fantastic carry.

Kshitij Anand: But if someone is looking at everything happening on the global and domestic fronts, what is your recommended approach for investors, let’s say, who have a 12- to 18-month kind of time horizon?

Shriram ramanathan: From a fixed income perspective, like I said, we are still, in a way, lucky that compared to the way bank fixed deposit rates are coming down very sharply, we still have fairly attractive yields as far as two- to three-year corporate bonds and short-duration funds are concerned— in the 6.75% to 7% zone—which is not a bad space to be in.

The second thing I would say is that now that we are in a stable regime, it is good to look at funds with a little bit of a yield-pickup play, wherein, in a measured way, you take exposures to AA+, AA, and AA– papers—maybe 25-30%.

Typically, a medium-duration fund would be a category like that, where you start playing the “instead of 6.75%, can I get 7.25% or 7.5% yield on the portfolio” approach while keeping the risk relatively measured.

I think the third thing—and this is a space that has really opened up, but requires a slightly longer investment horizon—is the income-plus-arbitrage fund of funds. That is a very tax-efficient instrument or vehicle available. For a two-year period, you get 12.5% taxation.

The underlying is a mix of arbitrage and debt funds, and the good part is that you can actively move across debt funds from one to another, with the fund manager making that choice, and as an investor, you are not impacted on the tax side.

So, I would say three products: One, short-duration funds for sure; two, yield-pickup medium-duration funds; and three, income-plus-arbitrage fund of funds. These are the three ways to play the next 18 to 24 months from a fixed income perspective.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)