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How debt fund investors need to temper their expectations in 2018

When the year 2018 began, there were two events that were being looked forward to. The first was the Union Budget and the second was the last monetary policy of the current fiscal year. Both are gone and the question now is what it means for debt fund investments. While we understand the budget impact on stocks market 2018, not too many people have focused on the impact on debt markets and debt funds. So, what are the investor expectations in 2018 from debt and debt funds? First, a look at the key indicators impacting debt funds..

Debt funds predominantly invest in government bonds and private sector debt and are largely dependent on the movement of interest rates in the economy. Additionally, factors like the government borrowing program and fiscal deficit estimates also have larger implications for the returns on debt funds. When you combine all these factors, what does it look like in case of debt fund investors in 2018? Here are 4 factors to consider..

Keep an eye on oil prices globally..
You may wonder what impact global oil prices may have on bond fund returns but the relationship is quite strong. For example, global oil prices have rallied sharply since the middle of June 2017 after bottoming out around the $45/bbl. In fact, oil has already touched $70/bbl in the early part of 2018 before settling around the $65/bbl mark. 

                                               Source: Bloomberg

The sharp rise in Brent Crude prices has been driven by a variety of factors. Firstly, the supply cut of 1.8 million bpd by Russia and the OPEC has worked in reducing the oversupply in the market. This supply is likely to continue well into 2019. Secondly, the US inventories have been reducing to a point where the demand for oil globally is higher than supply. The demand has also been facilitated by the rising GDP growth in Europe, China, Japan and the US. Thirdly, Saudi Aramco is planning a mega IPO this year and would be keen to ensure that crude oil prices do not crash till the IPO is completed as it will be critical to the valuations that Aramco can command in the open market. So oil prices will be headed higher and that means oil-driven inflation will be higher. This could put further upward pressure on bond yields and that is negative for bond prices and bond fund NAVs in India.

Fiscal deficit is likely to be under pressure in 2018..
The fiscal deficit reflects the gap in government funding. Under the FRBM, the government had set a target of 3.2% fiscal deficit for 2017-18 and 3% for fiscal deficit in 2018-19. In the latest budget, the government has indicated that it will be overshooting on both these targets. For the fiscal year 2017-18, the fiscal deficit is expected to be higher by 30 basis points at 3.5% and for the next year again the fiscal deficit is likely to be higher b 30 basis points at 3.3%. Why is this fiscal deficit relevant for bond markets? There are two reasons.
Firstly, fiscal deficit means more borrowing and that means more liquidity being spread across the people. Normally, greater liquidity is inflationary and that raises inflationary expectations. This is likely to push bond yields higher. Secondly, higher fiscal deficit means that the government needs to borrow more in the market. The government is the most blue-chip borrower in the bond market and when it borrows more it will crowd out other private borrowers. This will also put upside pressure on bond yields and push down bond prices further.

Bond yields are heading higher due to inflation and global bond yields..
The latest monetary policy of the RBI has pegged inflation expectations at above 5% in the first half of the year and slightly below 5% for the second half. That means inflation will continue to apply upward pressure on bond yields. If oil prices move up further then there is likely to be added pressure on inflation. Look at the 10-year bond yield chart…

                                           Source: Bloomberg

The sharp rise in 10-year bond yields since June 2017 has virtually coincided with the sharp rise in global oil prices and rising inflation. In addition, the US Fed is likely to hike rates by 100 basis points during 2018 with the first rate hike coming as early as March this year. The RBI may have to forget about further rate cuts and even consider the possibility of rate hikes to sustain the gap. The result will be higher bond yields during the year.

Indian bond markets must be prepared for higher yields during the year. The traditional bond funds with exposure to long maturities are likely to put up a tepid performance when the yields move up. While the movement may not be as sharp as last 6 months, the yields could still rise if inflation and oil prices do not show any respite. The moral of the story is that bond investors who actually made hay since the beginning of 2015 may actually have to temper their expectations on bond fund returns!

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