If you were tracking debt markets today, you would realize the euphoria is somewhat like the sensex touching 16,000 for the first time last year. At the core of the euphoria is falling inflation. A rising inflation had for better part of this year led the central bank to increase benchmark rates in the economy. With inflation easing off, there is increasingly a feeling that the central bank would take a pro growth stance and reduce interest rates. Bond dealers are a happy lot and they can once again look forward to a pro longed rally in bond prices.

Last year inflation spiked from single digit to 12.9% levels within a few weeks. Inflation was not the only worry on the mind of the then Governor of the Reserve Bank of India. The economy was obviously over heated, outlook on certain sectors did not make the central bank happy and the government had its coffers open to dole out farm loan waivers, salary hikes and subsidizing oil. RBI, though not early, was swift to react. However with the inflation being largely supply side driven, i.e fuelled by rising commodity and input costs, there was only that much one could do. Monetary action was still justified and the RBI increased benchmark rates to stem in inflation. Much of the situation has changed today.

A rising inflation strokes fears of interest rates going up. Increasing rates is seen as a negative for the industry and stock markets generally would react unfavorably to increasing inflation. Bonds are probably more affected by inflation. Bond prices are inversely related to interest rates in the economy. With rising inflation (or fears of rising inflation) come fears of rising interest rates, pulling down prices of government and corporate bonds.

Somewhere in July 2008, inflation hit a 13 year high. Bond prices took a hit with the 10 year government paper yield hitting a 9.5% late July. From then on, inflation started dropping and bond prices started picking up. Within 4 ½ months the bond yields fell to 5.44% a more than 400 basis point fall yielding a windfall to bond holders. Mutual Fund data released by Value Research shows the six-month average returns of Gilt Funds at 20% absolute and that of medium term bond funds at 10.12% absolute. Compare this with equity funds returns of the last six months at –34% and the BSE Sensex at –33%.

Most retail investors have not been able to participate in the bond rally. Buying bonds-government and corporate-is not easy. The better way to participate in bonds is through debt funds or bond funds. However most mutual fund companies were late in realizing the potential of gilts and bonds and thus were not able to sensitize their sales channels or advisors. Fidelity was the only notable exception with the AMC launching a Flexi Gilt fund in July, 2008. All is not lost though. Bonds are slated to have a good run for better part of 2009 that may stretch well into 2010.