By: Punam Sharma
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.
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