This is because the portfolio carry yield is at a higher level.

Every year gives a surprise. So much so, we are getting used to being surprised. In 2020, there was a pandemic. In 2021, we had the subsequent wave. In 2022, we had a war, global geo-political tensions, advanced economy inflation rate in the high single digit, even double digits. And central banks globally compete with each other to hike rates.

What 2023 has in store for us, no one knows. However, one thing can be said with a reasonable degree of certainty. Your returns from debt funds in 2023 will be better than in 2022. Now let me build my case. In this uncertain world, how can we come to this conclusion?
Whatever happens in the globe, in terms of recession or growth slowdown, we are comparatively better placed. The reason is, we are a large domestic economy, with dependence on exports on the lower side as compared to certain export-oriented economies. In 2022, when global commodity inflation was on the higher side, we managed it reasonably well through government policies.

We imported cheap oil from Russia, the government provided subsidy on fertilizers, etc. Our inflation was on the higher side as against RBI’s tolerance target of 6%. In comparison, in advanced economies with target inflation of 2% and actual inflation in high single digit, it was out of whack. Of late, there are signs of inflation peaking off from the highs, which is a sigh of relief and a positive for India. I am not talking of decoupling, as global linkages are undeniable. But when there is a storm, a tree with strong roots is better placed to survive.

Repo Rate Hikes

Reserve Bank of India has hiked repo rate from 4% to 6.25%, and is in the last leg of the rate hike cycle. There may be one more rate hike, taking the repo rate to 6.5%, in February or April 2023. Thereafter, the RBI is expected to go on a pause for some time, may be a year or so. Whatever rate action has been taken so far, has to be given time to percolate to the economy and impact inflation. Inflation is showing signs of easing. In November 2022, it was 5.88%, down from 7.79% in April 2022.

As per RBI projections, it is expected to ease to 5% as an average, in the quarter April to June 2023. Though the target inflation for RBI is 4% with 6% as the outer tolerance band, given the global situation, the target of 4% can be taken a bit easy for a year or so. This is as long as inflation stays within the tolerance band of 6%. Government bond yields have reacted to inflation data and RBI rate hikes till date, and any potential repo rate hike is more-or-less in the price. This is not to say G-Sec yield levels cannot move up further. Market yield movements would be driven by a fresh set of factors, from now on, rather than RBI rate action.

Debt Funds in a Better Place

Your debt funds are in a much better situation today than say two years ago. The reason is, the portfolio carry yield, or the approximate interest rate at which the instruments earn for you, is at a higher level. The portfolio carry yield, which is known as the portfolio Yield to Maturity (YTM), is not a guarantee or commitment on returns. However, it gives a sense of the returns that may be expected, over an adequate holding period. The only factor that may reduce your debt fund returns in 2023 is if there is any negative surprise and bond yield levels push up further.

However, chances are on the lower side. Crude oil prices are off the peak and at about $80 a barrel, it is lower than the RBI assumption of $100 a barrel, for their inflation projections. The war is not having much of an incremental impact on commodity prices; supply disruptions have happened and the world is gradually coming to terms. Our real interest rates have turned positive. With inflation at 5.88% and RBI repo rate at 6.25%, the gap is positive. Deposit rates at leading banks are now higher than 5.88%.

While G-Sec yield levels have more-or-less priced in RBI rate hikes, corporate bond yields have some limited scope of moving up. As an investor, you need not worry much about these market events, which keep on happening every other day. You may ignore the rear view mirror; the front view is reasonably clear now.

Source: https://www.financialexpress.com/money/your-money-debt-funds-to-give-better-returns-in-the-coming-year/2925341/