Debt Investment in India- July 2015

For an investor with a slightly longer time horizon (greater than 1 year), the fixed income market in India provides an excellent risk-adjusted opportunity:

1. Strong and Credible RBI:The current regime has shown very strong credentials in fighting inflation. Given their 4% inflation target by 2018, interest rates in India are set to head lower over the next couple of years. RBI will do what it takes to achieve this goal and though their maybe pain in the near term (unlikely: low probability event + a longer term investor should use every yield uptick as an opportunity), there is scope for interest rates to head lower by at least 100 basis points in this period.

2. Modi govt. resolve The fact that the govt. is in complete sync. with RBI’s monetary policy target is by itself an excellent indicator of their resolve to help in fighting inflation. This govt. seems to have realized that having an anti-inflationary stance is good politics as well. On the fiscal front, as the country moves towards the fiscal deficit target of 3% of GDP by 2017-18, there is bound to be a significant relief to inflation. Fiscal profligacy was the biggest reason for the high levels of inflation seen in India until as recent as 2013. This govt. has also shown commitment to keeping food prices under check by controlling speculative forces in the supply chain and by increasing supply as and when necessary to counter any disruptions in the chain which has been a major problem for years. Minimum Support Prices (MSP’s) continue to be in the 3-4% range, thereby ensuring the negative feedback loop into rural wages and increasing demand is minimized. In fact, RBI has identified these factors along with input prices as the most important determinants of food prices (monsoons, in fact, have a low correlation with food prices in the medium term, contrary to popular perception).

3. International commodity prices are expected to stay subdued given the slow growth + low inflation combination in all Developed Markets (Eurozone, Japan, and the US). China, a major source of commodity demand, is still facing demand headwinds and is yet to find a floor for its falling GDP. Crude is also unlikely to cross the mid 70 $ as shale supply increases in 2016 and other alternate/more efficient forms of energy gain prominence.

Thus, for an investor with a minimum 1-year horizon, returns of up to 2% p.a., over and above the base returns of 8% can be expected, i.e. 10% p.a. for a 3 year period. The best way to capture this opportunity is to invest in long duration debt funds (mutual fund route). If the investments are held for 3 years or more, the tax implication will be long term capital gains tax of 20% with indexation benefit (net tax would be in the range of 5-6%). This would ensure that the net yield to the investor would be approx. 9.4% p.a. post tax for a 3 year period.