Interest rates may have peaked and could fall - should you invest in debt funds now?

More experts predict fall in interest rates than a rise, which augurs well for debt funds.

On December 12, data shared by the government pegged the inflation at 2.33 percent. Earlier this month Bank of America Merrill Lynch (BoAML), a foreign bank had said that policy interest rates in India may fall by about 25 basis points either in February 2019 or April 2019, in a report.

Where are interest rates really headed?

If interest rates do fall, prices of debt securities rise (and vice-versa); the inverse relationship between interest rates and bond prices at play here. But why did BOAML expect a rate cut?

At the last monetary policy of 2018, the Reserve Bank of India (RBI) said that inflation is expected to come down. It expects inflation in the second half of 2018-19 to come down 2.7-3.2% (down from its earlier forecast of 3.9-4.5%) and down to 3.8-4.2% in the first half of 2019-20 from the earlier estimate of 4.8%.

In simple words, a fall in inflation means that the interest rates can come down too; the gap between interest rates and inflation is called real rate of return. In other words, if RBI’s latest projections on inflation come true (the latest inflation numbers already show a drop), there is scope for interest rates to come down.

“RBI expects inflation to go down in foreseeable future. If the inflation remains within the band expected, then the real rates need to contract in the form of a cut in policy rates,” says Sujoy Kumar Das, head fixed income- Invesco Mutual Fund. He expects the rates to fall by 100 basis points in CY2019.

“It is time to be cautiously optimistic. Though it appears that the worst is behind us, one should not ignore the intermittent volatility arising out of factors such as trade wars, crude oil and domestic political developments,” says Mahendra Kumar Jajoo, head of fixed income, Mirae Assets Global Investments (India).

Though experts are of the opinion that the rates may have peaked, there is no consensus on timing and quantum of the rate cut. What does that mean for your fixed-income investments? The possibility of a cut in interest rates will weigh on the minds of the fixed income investors.

Put in another way, some experts do not foresee any rate hike in near future. “With food inflation continuing to remain low and international oil prices falling sharply, there is no significant upside risk to inflation in the near future. There is thus no case made out for rates to go up. There is however no case for rates to come down either since inflation is likely to remain at around 4% which is the MPC’s target,” says Ashutosh Datar, Mumbai-based independent economist.

What Datar means is that if inflation remains at current levels, the RBI may not find much merit in hiking interest rates. A possible fall - or even steady - interest rates make the case for investors to take a look at their debt and fixed income investments.

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