Interest rates will have a mild upward bias because growth is strong, along with inflation: SBI Mutual Fund

Rajeev Radhakrishnan(left), CIO Debt, SBI Funds Management Pvt Ltd. and R. Srinivasan, CIO Equity , SBI Funds Management Image: Nayan Shah for Forbes India

SBI Mutual Fund, India’s largest mutual funds by assets under management (AUM) of around Rs 8 lakh crore ($97 billion), has a model that, at the moment, is positive on fixed income and negative on equities. Its chief investment officer-fixed income, Rajeev Radhakrishnan, who leads investment decisions for nine debt funds, says the fund house is seeing further inflows in hybrid funds that have seen increased investor interest.

Once retail investors see visibility on Reserve Bank of India (RBI) rate cuts—which will provide capital appreciation benefits in addition to higher yields—Radhakrishnan says the fund house will start seeing large inflows into debt products.

For now, the central bank will need to tackle the fresh spike in cereal and vegetable prices, seen in July. It could use liquidity management tools to deal with inflation and a rate hike could be the last resort. Radhakrishnan warns of a “mild upward bias” in interest rates.

In the equities segment, much of the money has been chasing small-cap stocks, prices of which have risen over 30 percent in the past six months. Valuations being expensive are likely to impinge on prospective returns for investors, says R Srinivasan, CIO-equities, who manages 13 equity funds.

Excerpts of the interaction with Radhakrishnan and Srinivasan.

Q. CPI inflation spiked to a 15-month high in July, led by cereal and vegetable prices. Do you expect more rate action from the RBI to deal with this?
Rajeev Radhakrishnan: The answer to this is multi-layered. On the one hand, inflation has been above the RBI’s target of 4 percent for a variety of reasons. This means the prospects for a rate cut in the near term look unlikely. Our view is that interest rates will have a mild upward bias because growth also continues to be strong, along with inflation. This creates the risk for perhaps yet another rate hike if inflation doesn’t moderate, heading into the next year.

But you have to keep in mind that we are the fastest growing economy in the world among the major markets. There are expectations that India will get included in the Global Bond Indices, which will lead to accelerated foreign portfolio flows into Indian government securities. These flows could, in turn, support yields as additional demand will be chasing the supply of paper.

The external situation is another backdrop that may influence yield direction. The Us Fed is likely to continue with the stance of policy rates staying higher for a bit longer, even as the balance sheet unwinding continues gradually alongside higher supply. The change in the Bank of Japan’s yield curve control policy is another dynamic that needs to be watched. This is because the Bank of Japan has been trying to normalise policy settings there and Japanese investors remain among the biggest investors in US treasuries. If Japanese Government Bond (JGB) yields start to rise, money will start flowing out of US treasuries into JGB’s, further pressuring US yields.

Q. When could investor flows into debt funds start to improve?
The present AUM in debt funds is a stable pool of money. We are seeing further inflows in hybrid funds that have seen increased investor interest. Institutional money in debt funds is preferring to come into the one-year modified duration products. We expect that once retail investors see visibility on RBI rate cuts, which will provide capital appreciation benefits in addition to higher yields, we will start seeing large inflows into debt products.

Incidentally, it’s important to note that debt is now yielding a positive real rate of return as markets’ yields are well above inflation. Thus, savers are able to grow and protect their wealth effectively via fixed income products.

Also read: Why global bond yields have risen again and how they may affect the rupee

Q. India's 10-year GSec yields have been rising in recent weeks due to inflationary concerns. Do you expect a further rise in bond yields, if we assume that the RBI may hike interest rate once more?
Apart from the higher domestic CPI print, bond yields have also been influenced by the uptick in global rates, especially the sharp jump in US treasury yields. One may witness a further increase in the near term if the RBI decides to tighten policy rates further.

At the same time, the net impact of those actions will also depend on how the domestic demand supply dynamics pan out, more so given the news flow surrounding possible Index inclusion. The base case is that given the domestic macro factors and possible RBI measures, the bias remains for an uptick in yields in the near term.

Q. Equities ran up to a record high in mid-July, before slipping on profit taking and weak macros. What is your assessment of how the trend could move?
R Srinivasan: We run a market timing model that is benchmarked to a 50:50 equity-debt allocation. That model effectively directs our views on equities. Right now, the model is negative equities and prefers fixed income. The extent of underweight to the 50:50 benchmark is 20 percent. We look at three variables: Earnings, valuations and sentiment. Earnings are positive, valuations are expensive while investor sentiment is neutral to positive; the latter is a contra indicator.

Also read: If Price Shocks Persist, We Have To Act: RBI

Q. Considering that small-cap stocks have risen smartly [record inflows into small-cap funds and over 30 percent for the Nifty small cap 50 index] in the past few months. Is there scope for a further rise or are we likely to see a correction in NAVs in this segment? What is your advice to new investors who might be planning to invest in small-cap stocks or funds?
Small-caps are a heterogeneous lot. It is tough, rather inappropriate, to talk about them as a homogeneous category. Having said that, it does feel like too much money is chasing the category. Valuations are expensive and will impinge upon prospective returns. We have enough small-cap stock ideas to fill up a decent-size portfolio but generally speaking, we would prefer large-caps to small-caps.