The bond market rally has hit a speed breaker, with RBI's note of caution on monsoon worries. Is this just a speed breaker in a longer rally or is it something that can break the rally? What should you do with client investments in duration funds? Should you stay put or switch to short term funds? Or, is this a time to aggressively add to duration fund allocations? Rahul gives us his perspectives on the current debt market scenario, the road ahead, and recommendations on product strategies for different client risk profiles.

WF: With RBI signalling a pause in its rate cut cycle, does the investment argument for duration funds now look weak?

Rahul: While RBI has not signalled a pause, but yes, they may wait for monsoon to play out before taking any further decision on rates. With close to 50 per cent weightage of food articles in the Consumer Price Inflation (CPI) index, the impact of monsoon remains an important factor behind food inflation trend in India.

While the sub-par monsoon is a risk factor, we note that the sensitivity to inflation has been on a decline (CPI inflation fell by ~300bps despite 12% rainfall deficit in 2014). This could especially be the case if global food prices remain benign and Government continues to undertake pro-active food management policies such as moderate Minimum Support Price (MSP) hike, offloading food stocks, etc.

With output gap still negative (RBI estimates potential growth at 8-8.5% based on new GDP series), and given our expectation of CPI inflation likely remaining in the range of 5.25-5.50%, by Q1, 2016 well within RBI's projected trajectory of 6% by Jan 2016, there could be reasonable scope for Central Bank to further reduce rates by 25-50 bps in the remaining part of the financial year. Therefore, we believe that investment case in duration funds remains strong.

WF: Some experts believe that RBI is behind the curve on cutting rates, which is not good for the economy and for markets. Do you share this view?

Rahul: While the RBI has cut repo rates thrice since the beginning of the year, all economic indicators that are fundamental drivers of interest rates like Current Account Deficit (CAD), Inflation and Fiscal Deficit remain conducive for further rate cuts.

With below normal prediction for monsoon, and potential rate hike in the US, it was difficult for the RBI to be more aggressive. Going ahead, much more rate cut may be needed, because in the current high interest rate environment, growth may not pick up.

WF: Do you see more volatility ahead for bond markets due to domestic and global uncertainties?

Rahul: While near term volatility in the markets is taking cues from global and domestic factors, this may recede once there is more clarity on the monsoon and US rate hike. We believe investors having a long-term investment horizon could create reasonable wealth by investing in debt mutual funds.

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