Should you remain invested in bonds?

Wed, 29 May Pre-Open

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We all know that bond prices move in a direction opposite to the interest rates. As the Reserve Bank of India (RBI) lowered key interest rates during last year; the prices of the bonds witnessed a steady appreciation, thus benefitting the bond investors. But does it make sense for investors to remain invested in bonds? Well, the answer to this question depends on what lies ahead for bond markets and the prospects of alternative investment opportunities.

As per an article in Business Standard, the future of the bond market will depend on RBI's actions regarding monetary policies. The RBI's actions regarding rate cuts will be governed by what happens to the inflation levels. As things stand now, if we exclude the impact of supply side factors, the inflation levels have declined. This can be attributed to the muted demand levels in the economy and a slowdown in the industrial sector. With crude prices softening, one might expect the rates to be lowered even further. However, as per RBI'S annual statement, the inflation in the second half is expected to be a higher than the current levels. This also implies that RBI will be cautious on further rate cuts to avoid an increase in inflation.

The recent drop in crude oil and gold prices brought temporary relief for the Government on the fiscal deficit front. In case the fiscal deficit eases drastically, one can expect Government borrowings to come down. This will reduce bond supply in the market and lead to appreciation in the bond prices. However, such a situation is governed by external factors (such as global crude oil prices) and can be temporary. Also, with elections around the corner, it will be over optimistic and naive to assume that the fiscal position will improve drastically. Hence, the likelihood that the Government borrowings will go up cannot be overruled. Such an event will lead a decline in the bond prices.

To be fair, the Government seems to have woken up to the fiscal alarm. It has surprised us by biting the bullet on the reform front. Some developments in the last few months such as phased hike in diesel prices and the like signal that the Government is quite desperate not to lose the confidence of rating agencies. If it maintains the current stand, the bond supply in the market should be in line with the borrowing plan for the next few months. This will imply stable prices for the bonds.

Coming to the alternative investment opportunity in stock markets, while the markets have gone up over the past few months, these are times of extreme volatility in the global economy. With high levels of economic coupling in the global markets and sluggish sentiments and weak fundamentals, we have little reason to be optimistic on equity markets in the near term atleast. As far as bond markets are concerned, the prices of bonds can offer stability provided government maintains fiscal discipline.