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Investment Insights

Suyash Choudhary

Market commentary since the latest RBI policy is fretting about how Governor Rajan has taken out prospects of a near term rate cut. Bond yields have risen sharply reflecting this sentiment. Admittedly, and as we had discussed in our post policy note, there was a dovish bias in the explicit RBI commentary in the June policy. This Rajan has sought to correct in the current policy. However, the underlying framework of the RBI has been consistent since January and remains so: RBI’s dominant policy target is headline CPI inflation. They want to bring this down to 8% by January 2015 and to 6% by January 2016. After that what anchor they pursue for CPI will be determined by their discussions with the government. With the August policy they have conclusively brought market attention back to this framework.
 
Markets will obviously fret about the change in expectation with respect to the first rate cut. This is because traders work with near term profitability targets. They also care about immediate term funding costs (which is linked to RBI’s current policy rate and liquidity management) since this defines their cost of holding positions. These technicalities drive near term price action in bonds. For investors and asset allocators, this imparts near term volatility to performance which is to be mitigated via appropriate investment horizons. The reasons for investing / asset allocating have to be more fundamental. We examine here the fundamental backdrop today and assess rationale for bond fund investing in that context.
 
Real Rate of Return
 
First principles first. Investments in fixed income create income, not wealth. And the predominant desire that a saver has (whether intuitively or explicitly) is for income to beat inflation. That is, savings should earn positive real returns. If the concept sounds theoretical, it shouldn’t. Inflation indexed bonds exist for this reason. Household budgets are dented or made partly for this reason. And finally, even the seasoned bond investor also, at least intuitively, buys bonds for this reason: it is not for nothing that the single largest longer term driver of bond yields worldwide is inflation.
 
Now look at the chart below:
 

 
The black line above is 10 year government bond yield. The purple line is CPI inflation. The orange bars are the difference between 10 year yield and CPI inflation; a proxy for real yield. As can be seen, real yield has been negative for most of the last 5 years. It was aggressively so till most of 2010. This period coincides with very loose fiscal and monetary policy that we now know contributed immensely to the building up of subsequent macro-economic risks. However, even after 2010 the RBI continued with a multiple indicators approach when setting monetary policy. On inflation the focus was always WPI inflation; much unlike elsewhere in the world. The Fed’s taper tantrums last year forced a rapid and somewhat disruptive adjustment to monetary policy as the cumulative domestic imbalances built over the past few years, became suddenly visible.
 
Given the context, bond strategies during this period (2009 – 13) were almost always tactical. Since there was never a fundamental reason to own large duration, our strategies used to focus on ‘seasonal triggers’ that impacted net demand versus supply dynamics of various parts of fixed income differently over different periods of time during a financial year. Thus for instance, we used to prefer shorter end rates during April – September coinciding with lower incremental credit to deposit ratio and hence lower supply. Over second half the preference used to shift to government bonds since RBI’s purchase of bonds used to pick up and issuance calendar used to lighten, thereby significantly changing the demand versus supply equation of government bonds for that period. The next financial year, the same cycle used to get repeated; of course with minor variations.
 
Investing with Rajan
 
In January 2014 the RBI unveiled a new framework with the Urjit Patel Committee Report. The anchor for monetary policy was shifted to CPI inflation with explicit ‘targets’ of 8% and 6% for years 1 and 2 respectively. The institutional credibility on inflation control has further got cemented with the new government’s complementary policies so far (and more to come) on fiscal stance and supply side measures. To be fair, the process of disinflation had started late last year with last 2 year’s relative fiscal discipline and MSP rationalization likely playing a role. However, with the mandate of the current government and the explicit framework of the RBI, the confidence that future disinflation will be achieved is now much higher. What is the most important to recognize in the current context is that rates are not high because we are suffering a macro-economic deterioration. Quite the converse, our macro-economic parameters including current account, inflation and fiscal deficit are improving at an enviable pace. Instead rates are high because the RBI is working with more stringent thresholds on inflation than it has ever before in the past. Put another way the RBI is encouraging savers to invest for income, and it will ensure that fixed nominal return financial assets deliver positive real returns.
 
If investors agree with this view point, then this is the biggest reason to invest in bond funds today; not when the RBI will be able to cut rates.
In the previous regime’s multiple-indicators, WPI oriented approach, repo rate would already likely be much lower now. This would have caused bonds to rally and thereby provided immediate year 1 gratification to bond fund investors. However, by definition, the cycle would have been shorter and ,correspondingly, future real returns would have turned volatile. Instead the current regime is providing a strong opportunity to earn relatively more stable positive real yields in the years ahead. Obviously, distribution of returns will still have some volatility depending upon expected and actual path of future policy action. However, given the stability and focus of the RBI’s framework and with every reason to expect complementary action from government, perhaps for the first time in 5 years there is now a fundamental reason to buy bond funds. And the reason is not an early expected rate cut but the fact that the RBI is bent on providing real, sustainable, positive returns to long term bond holders.

 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.

 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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Suyash Choudhary

The RBI in its policy review today announced the following:
 
1. Kept all policy rates and liquidity windows unchanged
 
2. Reduced SLR ratio further by 0.5% to 22% of net demand and time liabilities (NDTL) for banks
 
3. Held to maturity (HTM) category for SLR security holdings of banks reduced by 0.5% to 24% of NDTL.
 
Interpretation
 
To our mind, the chief take-away from the policy today was that the RBI moved to correct the unintended dovish interpretation that the June policy review had perhaps lent itself two. In that policy the language was somewhat asymmetric in the sense that although the central bank explicitly mentioned that higher than currently anticipated disinflation will allow monetary easing, it did not mention the converse. While it may be argued that this was implicit, as we know markets tend to focus very closely to central bank language especially when they anticipate that the direction of policy may be about to change. Be it as it may, the policy today has firmly re-anchored market expectation towards RBI’s inflation objectives of seeing January 2015 CPI at 8% and January 2016 at 6%. Towards this, the assessment is that risks to 8% target are now more balanced than they were in June; presumably owing to the continued disinflation that we have seen over the past 2 inflation prints. However, the RBI sees still upside risks to its next target of 6%. This is a fair assessment since while the pace of disinflation post September 2013 has been noteworthy, it is also true that the 6% target is quite ambitious given India’s recent history.
 
Takeaways
 
The policy today doesn’t really provide any fresh information about RBI’s stance and reaction function. Ever since the Urjit Patel Committee recommendations in January, it has been very clear that CPI inflation will be the dominant anchor for RBI policy. Not just this, what has been equally clear is that both the 8% and 6% targets on CPI are sacrosanct for the central bank; even though future targets after that may be arrived at in consultation with the government. It is for this reason that we haven’t believed that there is any chance of a near term rate cut by the RBI. However we also believe that, given complementary government action, the requisite pace of disinflation will likely be achieved without further rate hikes. For this reason, we think that the rate cycle has peaked even though a rate cut may be sometime away and the rate cut cycle itself may be shallower.
 
What Should Investors Do
 
The policy today has induced some short term volatility in the market. This is because the SLR/HTM cut may be perceived to be negative for bond demand on the margin. This may weigh on near term sentiment all the more since August has the highest net supply of bonds. Also, there was at least a section of the market that was expecting a rate cut in the next quarter. This expectation will now need to get revised.
 
Investors should note that these are all near term technical issues, capable of imparting a 15 -20 bps volatility to bond yields. The broader picture, as far as we are concerned, is as follows: Bond yields are where they are because we have a pro-active central banker who for the first time in recent history is endeavoring to anchor CPI inflation to 6%. Note that CPI is already falling and in the earlier regime interest rate cuts may have started already, with corresponding near term gains to bonds as well. However, this again would have imparted more medium term risks to monetary policy since frequency of adjustments to policy would have been larger and more 2-way. For asset allocators to fixed income duration that would not necessarily have constituted the most optimal scenario; as the last year has well illustrated. Instead, in the current set-up monetary policy will only react to sustainable medium term fall in inflation. Given the credibility of the current RBI plus government combination, it is not that difficult to expect that CPI inflation over the next few years may average closer to 6 – 7% as opposed to the 10% plus that it has averaged over the past 5 years. This means that bond investors can look forward to ‘real’ yields of approximately +2% from the -2% that has been experienced over the past years. This, to us, constitutes the single biggest reason to be invested in bond funds for a fixed income asset allocator. Obviously, while making such allocations investors need to be cognizant of their near term appetite for volatility as well as their intended time horizon.
 

Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends.This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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