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Informist, Wednesday, Jun. 18, 2025

 

By Aaryan Khanna

 

MUMBAI – Mutual funds are shifting their focus towards short-term bonds and divesting out of government securities in the hope of capturing higher yields on corporate debt investment. The market's view that capital gains would continue to accrue for a while has now evaporated almost entirely after a stunning run over the past year, and portfolios will now reflect maximising interest income in a challenging environment, fund managers said.

 

Yields on both sovereign and corporate bonds had risen by 15-25 basis points after the Reserve Bank of India's Monetary Policy Committee cut the policy repo rate by 50 bps to 5.50% and changed its stance to 'neutral' from 'accommodative' earlier this month. Traders remain uncertain on whether the rate-setting panel will cut interest rates in the remainder of 2025-26 (Apr-Mar) after bringing down the policy rate by 100 bps since February.

 

Comments by RBI Governor Sanjay Malhotra at the post-policy press conference suggested the MPC had a high bar for rate cuts going ahead, though some of these concerns have been dialled down after Malhotra said in an interview Tuesday that lower inflation could open up further space for policy easing. This has led to bond yields easing in the last two days.

 

"June MPC was clearly a dovish policy. I feel the market may be over-reacting to the neutral stance," said Dhawal Dalal, president and chief investment officer – fixed income, Edelweiss Mutual Fund. "From the fixed income investment perspective, the focus will shift to carry rather than potential price appreciation as the policy reaches at the fag end of the rate cut cycle. There are no more surprises for the market to look forward to."

 

Expectations of capital gains had led most mutual fund houses to increase their holdings of government bonds maturing in 15 years and beyond, for which price gains are higher per basis-point-move in yields. In FY25, the 10-year benchmark gilt yield fell 47 bps, while the yield on the 40-year benchmark 7.34%, 2064 bond fell 39 bps from the par yield level it was issued at in April 2024. CRISIL's Long Term Gilt Index delivered a return of 13.89% in the 12 months to April, the second-most among all fixed income indices – the index for long-term 'AA-' bonds was at the top – while the 10 year Gilt Index returned 12.58%. However, gains in the 10-year and short-duration bonds far outstripped gains in longer-term gilts between the April and June monetary policy reviews, after some traders reassessed their allocation to long-term gilts. 

 

That move would begin in earnest now, with potential capital gains also likely coming from corporate bond spreads against gilts shrinking, fund managers said. Mutual funds have sold INR 115 billion worth of government securities in the eight trading days from the policy on Jun. 6 to Tuesday, with over INR 60 billion on the policy day itself, according to Clearing Corp. of India data. Some mutual funds also hit stop-losses on their holdings of erstwhile benchmark bonds – the 7.10%, 2034 and the 7.30%, 2053 gilts, they said.

 

Carry is the spread earned by an investor from the return on a fixed income instrument over its funding cost, and funds are looking at the short-term segment with interest after the five-year benchmark 6.75%, 2029 bond's spread over the repo rate widened to over 50 bps in the last few days. The yield on the bond had fallen to below the repo rate in May and early June on the cusp of the expected rate cut, though the expectation was only of a 25-bps cut. 

The effective cost of marginal funding for banks and mutual funds is even lower than the repo rate. The Mumbai Interbank Offered Rate, a benchmark for money market rates, fell to a 33-month low of 5.30% on Tuesday, near the lower end of the Liquidity Adjustment Facility corridor. While banks are also making use of the strategy, mutual funds say they are more nimble in stepping up investment in high-rated corporate debt. The top-rated five-year bond issued by the National Bank for Agriculture and Rural Development has a spread of 72 bps over the five-year gilt on Wednesday.

 

"While the corporate bond spread has compressed by ~15-20 bps on the shorter end, lower absolute levels in IGBs (Indian government bonds), lower differential with US treasuries point towards a gradual reallocation towards corporate bonds to chase the carry," HSBC Mutual Fund said in a note last week.

 

SMALL HICCUP

The trend is set to pick up steam as bond markets stabilise, because traders are currently reassessing the domestic monetary policy trajectory as well as the impact of the Israel-Iran conflict. Spreads between corporate bonds and gilts in the five-year segment may shrink by around 10 bps to around 60 bps by July-end, dealers said. Several funds have retained their liquid gilt investments rather than move to corporate bonds as they navigate the uncertainty in the market. With the conflict expected to settle within the month, incremental flows may begin heading to corporate debt soon, fund managers said. However, should the conflict in West Asia extend further, fund managers will be more picky in chasing the carry in more illiquid instruments such as corporate bonds.

 

The bias towards spreads narrowing is expected to last till September-end, when traders brace for both the October MPC meeting and a new borrowing calendar for gilts. The five-year gilt is seen in a range of 5.80-6.00% in the medium term, against 5.93% on Tuesday, while the five-year corporate bond is seen at 6.40-6.85%, against around 6.77% Tuesday.

 

Regardless of future rate cuts, overnight funding costs are expected to remain capped around the policy repo rate as liquidity in the banking system is expected to remain in hefty surplus. Market participants expect the RBI to maintain the surplus at around 1% of banks' net demand and time liabilities, or around INR 2.40 trillion. This would get a further boost later in the year, when a cash reserve ratio cut adds INR 2.5 trillion to the banking system between September and November-end.

 

"This (large liquidity surplus) should drive short-term bond yields further down and supress the yield spread on corporate bonds over government bond. This might present an opportunity for capital gains in short- to medium-term corporate bonds," said Pankaj Pathak, fund manager – fixed income at UTI Asset Management Co. "We believe up to 5-year maturity good quality corporate bonds are favourably positioned in this environment."  End

 

Edited by Avishek Dutta

 

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