ETMarkets Smart Talk | Bond markets have priced in nearly four rate hikes. Where should investors invest now? - The

Bond markets have undergone a sharp repricing in recent weeks, with yields moving higher as liquidity tightens, inflation concerns persist and expectations of further policy tightening build up.With the market already pricing in nearly four rate hikes, the key question for fixed-income investors is: where should they invest now?Should investors stick to money-market and short-duration funds, gradually move into the intermediate segment, or lock into longer-duration bonds after the recent rise in yields?In this edition of ETMarkets Smart Talk, Piyush Barawal, Director and Senior Fund Manager at WhiteOak Capital, shares his outlook on interest rates and bond yields and explains why the two- to four-year segment of the yield curve could offer an attractive opportunity.

Edited Excerpts -Q) We have seen bond yields rise, liquidity tighten and expectations around the RBI's next policy move shift. What has fundamentally changed in India's fixed-income market over the past few weeks?A) Over the past few weeks and months, quite a few things have turned adverse for Indian fixed income. Globally, the AI-led rally has been one factor attracting capital away from Indian equities, creating pressure on the INR, which in turn also makes Indian bonds less attractive for foreign investors.Parallelly, global yields, including in the US, have risen sharply on elevated fiscal deficits and sticky inflation, while higher oil prices and the unresolved West Asia situation have added to inflation woes.

Domestically too, inflation concerns have increased and RBI has started tightening policy.Liquidity too moved from large surplus after the FCNR inflows to near-neutral levels, partly because of FX intervention, OMO sales worth around INR 1.25 trillion and other liquidity drains.This has reduced support for bond demand and made the demand-supply equation less favourable. Together, these factors have caused a sharp repricing of Indian bonds by pushing yields higher.Q) Looking beyond the October US Fed meeting, what is your base case for the Fed's policy trajectory through the first quarter of 2027, and what developments could change that outlook?A) After hiking rates in September, Fed paused in October, while describing economic activity as strong and inflation as elevated.Markets are currently pricing ~ 2 more rate hikes by March 2027, which is reasonable if the current growth and inflation backdrop broadly continues.However, a lot will depend on how inflation and growth evolve.

Oil prices and the West Asia situation, tariff-related pressures, consumer demand and the ongoing AI capex cycle can all influence the outcome.If these keep demand and inflation stronger than expected, the Fed may have to act more hawkish. If some of these pressures ease instead, the need for further hikes could reduce. Labour-market data will also remain important.A meaningful weakening in jobs or growth, especially along with softer inflation, can give the Fed room to pause.

On the other hand, if growth continues to hold up and inflation remains sticky, the market may have to price in a longer tightening cycle.Read more: ETMarkets Smart Talk: Bond yields may rise further over the next few months; avoid aggressive duration and credit bets: Suyash ChoudharyQ) Could a more hawkish Fed trigger further pressure on the rupee and foreign portfolio flows into Indian debt, even if the RBI keeps domestic rates unchanged?A) A more hawkish Fed could lead to a further rise in US Treasury yields and, ceteris paribus, add to pressure on the INR and FPI flows into Indian debt, especially if domestic rates remain unchanged.A narrowing interest-rate differential makes Indian bonds less attractive for foreign investors, while currency depreciation further reduces dollar returns.Rate hikes can thus help take some steam off by improving the interest-rate differential and signalling policy credibility.

INR pressure is therefore another factor, apart from inflation, that can keep the RBI relatively hawkish.Q) How should investors choose between fixed deposits, government securities and debt mutual funds?A) Fixed deposits may be preferable for investors who have a fairly clear investment horizon and want near-certainty of returns. However, if the money is needed earlier, the applicable interest rate is usually lower and there is often a penalty applicable.Direct investment in government securities requires investors to adjust duration and manage reinvestment themselves, even as the secondary-market liquidity of those securities can be poor, especially in non-market lots.Debt mutual funds thus offer a more convenient way to access a diversified fixed income portfolio without needing to decide the tenure beforehand.

Also, buying and selling of securities within the fund does not create a tax incidence for the investor, allowing returns to keep compounding on a tax-deferred basis.For many investors, therefore, debt mutual funds can be a better alternative. Hybrid funds can also be considered where investors want exposure to fixed income alongside other asset classes and these can potentially offer better tax efficiency.Q) What is your outlook for interest rates and bond yields over the next three to six months?A) We do expect further rate hikes over the next few meetings, but believe the market is already pricing in nearly four rate hikes.

Bond yields across the curve have risen sharply in response. Global yields too have moved up materially, although there has been some retracement from recent highs.Given the extent of tightening already priced in, we believe yields in the two- to four-year segment may have limited room to rise sharply from here and could even soften if the eventual policy tightening turns out to be less aggressive than currently feared.While longer-duration yields have also risen significantly and spreads over US Treasuries have improved, we are still not convinced that the long end has turned attractive, given elevated US real yields and continuing concerns around INR depreciation.

The long end may remain vulnerable to adverse global or domestic developments over the next few months.Read more: PMS Talk: AI, defence and electronics manufacturing are the next growth engines, says Vaibhav AgarwalQ) What is the one fixed-income strategy investors should avoid in the current environment?A) We would be cautious on strategies that take meaningful exposure to lower-rated credit in the current environment.

When liquidity tightens and there is greater competition for capital, weaker corporates generally find it harder and more expensive to borrow.Credit spreads can widen, and financial stress on marginal issuers can increase the risk of downgrades or defaults. Such portfolios can also face liquidity issues if redemptions rise, as lower-rated papers are often difficult to exit without taking a price hit.At present, the additional yield available in this segment may not adequately compensate for these risks.

We would therefore prefer higher-quality credit at this stage.Q) Debt mutual funds saw outflows of ₹1.83 lakh crore in September. Should investors interpret this as a loss of confidence in fixed income, or was it largely a temporary liquidity-management phenomenon?A) Debt mutual funds typically see large inflows at the beginning of a quarter and correspondingly large outflows towards the end, particularly in categories used for treasury management.Of the overall ₹1.83 lakh crore of outflows in September, around ₹96,000 crore came from Liquid Funds, ₹51,000 crore from Money Market Funds and another ₹12,000 crore from Ultra Short Duration Funds.Together, just these three categories accounted for nearly 87% of the total outflows.

These are largely regular treasury-management flows, and one should not read too much into the seemingly large headline number.Q) Should investors favour short-duration and money-market funds in the current environment, or does the rise in yields create an opportunity to gradually lock into longer-duration funds?A) Money-market and very short-duration funds make sense if the investment horizon itself is short.

Investors with an investment horizon of at least a year however should not restrict themselves to the very short end.We believe yields in the front to intermediate part of the curve, particularly below five years, are quite attractive even after factoring in the possibility of multiple RBI rate hikes.The current environment therefore offers an opportunity to invest in this segment through appropriately positioned short- to medium-duration funds.

However, we are still not convinced that longer-duration yields have become sufficiently attractive, despite the sharp rise seen there as well.The long end remains more sensitive to inflation, pressure from a weakening INR and any rise in global yields. Therefore, we would not suggest going all out on long-duration funds at this stage.(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)