With one rate cut behind us and another one looming ahead, how can investors leverage fixed income investments in a volatile and falling interest rate environment? In the April 2025 outlook, we’re going to discuss the nature of the interest rate cycle, the key drivers behind rate cuts, the risk return framework for investors, and product choices.
Fixed Income Investment Strategy:
Investors need to focus on reinvestment risks and opportunity costs rather than absolute returns. Select products that can adapt to lower interest rates or that can lock-in returns.
RBI Monetary Policy
Why was the RBI inclined to cut rates in February? It boils down to one thing: liquidity. India’s growth may have slowed down, but it is by no means slow. Inflation remained elevated until the February CPI came in at a 7-month low. The worst of food inflation seems to be behind us, but monsoons may still play spoilsport.
So, by design we could expect a shallower interest rate cut cycle. One that is focused more on boosting liquidity and releasing the tightness in the system from fiscal consolidation and constrained spending. For liquidity to come back, transmission is key. Government spending may inch up if tax collections, divestments, and dividends improve. Private spending is harder to solve for: requiring a multi-pronged policy push.
The RBI’s stance remains neutral because risks may present from any direction.
Rethinking Risk
What risks are top of mind for an investor today? First, equity is proving to be a fickle asset after a dream run. Second, inflation seems to be cooling off. Third, the yield curve still appears flat. Lastly, unsecured lending seems to be a ticking time bomb.
An investor then needs to solve for liquidity and capital protection. Fixed income could work for aggressive and conservative investors alike. It opens up a space to pause and grow their wealth in a challenging market year.
With lower inflation risk and lower interest rates, investors need to prepare for reinvestment risk. This means locking into longer term assets at the right valuation. With a flat yield curve and a slowdown in FII Index based flows, investors must pay attention to entry yields. A shallow rate cut cycle means limited up side.
Product Choices
With fixed income, one must always prioritize safety over returns. This cycle merits a cautious approach. With bonds and performing credit (AIFs) the investor must do their diligence at the issuer level. The RBI has proactively intervened in the microfinance and NBFC sector. As households and businesses leverage, they must deleverage as well. Deleveraging can be painful.
Investors may consider locking into high-quality long-term returns or agile products that adapt to changing environments.