Strategy for debt investors in the wake of rising inflation

After remaining non-existent for the past few years, inflation fears have resurfaced. The consumer price index (CPI) inflation for May surged to 6.3% on a year-on-year basis. The headline inflation is now expected to average around 6% in FY22, against earlier forecasts of around 5.1%. How does it impact the market and investors?

Higher inflation

“The higher weightage of 46% of food and beverages indeed points towards a possible spike in inflation number but with proper buffer stocks of grains and benign monsoon forecast, vegetable and fruit prices are likely to remain in check after seeing some volatility,” Dwijendra Srivastava, CFA, and chief investment officer – debt at Sundaram Mutual said.

In absence of suitable demand triggers, WPI inflation cannot be completely passed on to the retail level, also the correspondence of WPI with CPI is low. Having said that, we cannot rule out higher inflation trajectory on further/prolonged supply disruptions especially for items with inelastic demand, Srivastava added.

A higher inflation is a tax for a marginal consumer who has to either change his basket of consumption or lower consumption altogether to fit her budget. For investors, it means less savings as real return reduces and the only way to achieve her savings target is either to increase her savings to meet target amounts or take more risk for having real returns over the target horizon.

RBI’s policy normalisation

Amidst the expectations of rising inflation, RBI’s policy normalisation has to be looked at with MPC (Monetary Policy Committee) mandate to manage inflation with an eye on growth.

“Even at this juncture when growth is flagging and negative output gap being substantial, RBI’s priority seems to be growth and they are willing to look through the inflation numbers till the growth picks up. Having said that if at any time MPC/RBI considers inflation to destabilize the financial fabric, they may look to normalize the policy,” Srivastava explained.

Bond Yields

Bond yields are resolutely anchored to the largest player (RBI) moves in the market. With mostly domestic investors in sovereign debt, it has been easy for the central bank to influence the bond yields through its Open market operations and now GSAP (G-sec Acquisition Program).

“Although government revenues are looking good as the economy is slowly opening up, higher government bond yields means an additional burden on the government in these trying times. We believe RBI will let the yields rise slowly as the economy improves and interest payments as a percentage of expenditure remain below 25%,” Srivastava further explained.

Meanwhile, according to Ajinkya Kulkarni, the co-founder at Wint Wealth, the government bonds maturing in 2050 are giving a fixed return of 6.7% as of now. If you think the interest rates will be low after 10-15 years, it makes sense to invest in these bonds from the point of long-term investment.

However, if you are looking for absolutely safe investments for the short term and with a small amount (less than Rs 5 lakhs), go for FDs. In the long term (>10 Years), you can consider government bonds as a better option.

The strategy of conservative debt investors?

Assuming that a conservative debt investor has a one-year time horizon, one can look to invest in schemes that have low risks. With SEBI coming out with Risk-o-meter labeling of funds, it’s important for investors to match their risk appetite with the fund labels.

“Having said that it is important to note that the yield curve is very steep (longer maturities are at higher rates compared to shorter-term rates then the normal time spreads) and the temptation to go up the curve in longer product is compelling to make a real return/ less negative real return on a YTM (Yield to Maturity) basis of portfolio but this strategy is fraught with duration risk which could come in if the target horizon is not matched with portfolio duration,” Sundaram Mutual’s chief investment officer for debt asserted.