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Investment Insights

Suyash Choudhary

There are two strong sets of dynamics to the bond market today. These are described below:
 

MACRO FACTORS
 
1. Weak Growth: Prospects for global growth have continued to deteriorate with ample signs that the manufacturing / investment cycle in most parts of the world is deteriorating sharply. This is readily visible in a wide array of commodity prices most chiefly in items like oil and metals. The deterioration in global growth is impacting India’s prospects as well, most directly via a collapse in total trade. Additionally, banking credit growth remains weak and so does private sector investments.
 

    2. Strong External Stability: In an environment of weak global growth and credit concerns, there are many emerging markets (EM) that are facing significant external vulnerabilities. This has put pressure on currency and hence interest rates in these countries. In stark contrast, India now runs a positive basic balance (current account deficit plus net foreign direct investment). This, alongside stable public policy, has enabled us to cut interest rates in an environment of considerable global uncertainty. The same dynamic is likely to persist in the time ahead as well.

 

    3. Proactive Government Policy: The government has shown a strong commitment to both fiscal consolidation as well as food supply side management. Alongside the effect of crashing global commodity prices, this discipline has helped break the back of India’s structural inflation. Despite considerable political pressure, the government has also so far resisted taking the consumption stimulus route; instead focusing on rebalancing spending into investments. This has both a stronger future growth multiplier as well as is relatively non-inflationary.

 

    4. Accommodative Monetary Stance: Against all expectations, the RBI has delivered 125 bps rate cut in the calendar year 2015. It has also stated that the stance of policy remains accommodative and the central bank will look for more emerging room to cut rates. In terms of the three pillars of RBI policy – rates, communication, and liquidity- it has already plugged the first two. Thus not only has the central bank cut rates, it is also sounding much more dovish than it was right up till mid-year. At some juncture if it chooses to modify its liquidity stance as well, then that would be extremely bullish for interest rates.

 

A clear takeaway from an assessment of the macro factors is that bonds remain a very strong asset allocation story. This also means that despite recent fatigue, it is inadvisable for investors to take ‘cash calls’ on their bond investments.

 

TECHNICAL FACTORS

 

Despite the underlying story, the frustration felt this year has been quite real. This has spanned investors and traders alike as the mid to long end of the yield curve has largely refused to budge despite the hefty rate cuts. However, two points bear mentioning here:

 

    1. The mid to long end of the yield curve performed extremely well when it rallied 100 bps from 9% to 8% in response to CPI almost halving and in anticipation of future rate cuts from RBI. Hence over a 1.5 year period starting from mid 2014, the mid to long end has done extremely well. It’s just that its performance has been front loaded over the first 6 months of this period.

 

    2. Even during the period of non performance of the mid to long end of the curve (over this calendar year), it is not as if there has been no performance on the bond curve. As is clear from the graph below, from virtually a fully flat curve at the start of the year, the yield curve has steepened somewhat has the short end has responded to the RBI rate cuts while the long end  has been held back.

 

 

The ‘blue’ curve above is the latest sovereign curve whereas the ‘red’ is the curve as at 1st January 2015. While yields have actually risen for the 15 years and beyond segment, they have fallen for shorter tenors. There have been technical factors at play that have led to the under-performance of the mid to long end of the curve. Most simply put, there has been a mismatch in demand versus supply of bonds in these tenors. Some of these technical factors are summarized below:

 

    1. Banks have traditionally been the strongest anchor investor class for bonds. Indeed, given the current environment where there is a ‘positive wedge’ between deposit growth and credit growth, they have been running an excess SLR book amounting to 6 – 7% of their deposit books. However, what has hurt appetite on the margin is the fact that all the excess SLR has to be held outside the so called ‘held to maturity’ book and is therefore subject to mark to market. Thus even though banks may have the capability to buy, incremental appetite has been at least partially hurt because bond investments have turned loss making. In an environment where there is anyway a tall ask on their risk capital owing to rising credit costs, their appetite for incremental losses on their investment books as well would be quite limited.

 

    2. Traders including banks and primary dealerships are broadly suffering a similar dynamic. Appetite for incremental loss taking is limited given constraints on risk capital and hence position sizes in the market have progressively been marked down. This section of the market has been an important swing player both to match the demand versus supply equation as well as in creating momentum in prices. This is largely absent now.

 

    3. Provident fund (PF) and insurance companies remain consistent buyers. However, here as well there are 2 additional factors of note: One, supply of state loans (SDL) that are available at a decent spread over government bonds is higher by about INR 35,000 – 40,000 crores in the current year which is helping satiate PF and insurance demand and hence weakening the bidding in longer end government bonds. Two, LIC is also contributing debt funding to Indian Railways to the tune of INR 150,000 crores over the next few years. If not for this, this money would have gone into bonds.

 

    4. RBI used to be a net buyer of government bonds to the tune of INR 125,000 – 150,000 crores during the 3 years prior to FY 15. This used to provide a significant boost to bond demand. However, since last year it has turned a net seller as most of reserve money creation has been happening through accretion of forex assets rather than the central bank having to buy bonds from the market. This is also an important change as far as the demand versus supply equation is concerned.

 

    5. Foreign portfolio investors (FPIs) are no longer the important swing factor that they used to be earlier. This is because the RBI is allowing gradual increases in their participation over a longer period of time. Hence while they may still constitute an important source of demand when the next couple of years are considered in total, their incremental participation per quarter no longer changes the demand versus supply equation meaningfully.

 

Looking ahead, most of these technical factors may continue to persist for the mid to long end of the curve. In fact there are a few additional factors that may pose as additional causes for concern. These are:

 

    1. The new discom restructuring package (UDAY) envisages interest saving for power discoms by replacing a large portion of high cost loans provided by the banking system into lower yield bonds issued by state governments. Approximately INR 4.3 lakh crores worth of loans may be affected by the package, a significant portion of which may eventually get converted into state government bonds. This will depend on how many states eventually decide to take part in this voluntary scheme. Once the bonds are created they may constitute an additional source of supply over a period of time.

 

    2. The total government bonds maturing in the next financial year are around INR 225,000 crores versus INR 145,000 crores in the current year. This number may go down somewhat after the current year’s bond switch are executed. Nevertheless, gross bond supply in the next financial year will be higher from this year by a significant margin purely on account of these maturities, even if net borrowing remains exactly the same. Since most of the issuances happen at the mid to long end of the curve, these bonds may face additional pressure on account of the higher gross supply.

 

It must be understood that RBI can still step in and balance the demand versus supply equation via purchasing bonds from the market. The justification for this can be sought either from perspective of reserve money creation (since forex asset accretion has again slowed down lately) or from ensuring that sustained transmission of previous rate cuts happens (since banks cannot continue transmitting if risk free curve refuses to budge).  If this were to happen in a significant way then it can completely alter the demand-supply dynamic for the mid to long end of the curve and refocus market attention to this segment. However, pending such an action we think there is a strong likelihood that, for the reasons mentioned above, the steepening bias in the yield curve persists. It must also be noted that even though the yield curve has steepened relative to what it was a year back, it still remains reasonably flat.  The long end yields have risen not just because of natural steepening tendency but also because volumes there are low and hence market is now attributing a higher illiquidity discount to those bonds. Adjusted for this, the steepness between an 8 and a 25 year bond is only about 15 bps. The true steepness on the curve is between the overnight at 6.75% and the 5 – 9 year segment which is more than 100 bps higher on an average.

 

PORTFOLIO STRATEGY

 

The following summary points need to be highlighted from above:

 

    1. The mid to long end of the curve performed strongly in the first phase of India’s macro adjustment. For the last year, even though the environment has remained conducive for technical reasons this part of the curve has stopped performing.

 

    2. Performance has moved to the ‘front’ part of the curve (loosely defined as 0 to 8 years) where the steepness versus overnight is maximum and the technical factors plaguing the mid to long end are largely absent. This is because the government no longer borrows in 5 year bonds whereas supply in the 6 – 9 year segment is also only around 20% of total supply.  Additionally, there is a very clear ‘roll down’ visible in this sector. As an example the 5 year sovereign bond is at 7.70% whereas the 3 year is at 7.50%. Thus even if the yield curve remains static, the yield on the current 5 year will fall by 20 bps over the next 2 years. This is what is meant by roll down.

 

    3. The macro reasons to remain engaged in interest rates is very strong. Hence, we would strongly discourage investors from taking any ‘cash calls’.

 

Respecting the above dynamics, and in line with our active managed stance across the platform, we have moved a majority exposure in our bond and gilt funds from the mid to long segment into the 5 – 9 year segment. This trade has already worked well over the past month as the yield curve has continued steepening. For the reasons mentioned above, we think that going forward and especially into the new financial year, the yield curve may steepen further. This means that the 5 – 9 year sector may continue to be the performance driver for the foreseeable future; barring of course incremental action from the RBI to stem the demand supply mismatch at the mid to long end sector of the curve.

 

In conclusion then, in an overall supportive macro environment for rates, we believe that performance drivers have shifted further to the front of the yield curve. We are accordingly positioning our bond and gilt products to benefit from this phenomenon. Investors need to do nothing but continue to look at these products from an asset allocation perspective.

 

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 about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions 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 recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. 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. Neither 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 policy review today was largely along expected lines. On macro factors, broad concerns remain with respect to the uneven global recovery and the weak world trade situation. In particular China continues to see slowing nominal GDP growth in context of high debt and other EMEs continue to face headwinds as well. On local dynamics, the growth situation is mixed with agriculture remaining subdued, some uptake in new manufacturing orders and decline in finished goods inventories, and mixed indicators from the services sector. On inflation there has been an uptake in CPI as previously envisaged by the RBI with both food and services inflation ticking up in the last few readings.

 

Key Takeaways:

 

These takeaways are both from the policy as well as from the media call with the RBI subsequently:

 

1. The RBI has emphasized that the stance of monetary policy continues to be accommodative and it will use room, when available, to cut rates. This is key in terms of policy guidance since, as may be remembered, the guidance till June used to be far more tentative and cautious even though the central bank was cutting rates.

 

2. Importantly, it has clarified how it is likely to interpret the inflation impact of the 2 key events coming up: 7th Pay Commission and the GST. It has said that it is likely to see through the impact of pay commission on CPI via the HRA route. Similarly, it has said that it will likely ignore the bump up in services inflation via higher service tax after GST since the rise in inflation will not be on account of higher wages.

 

3. It has continued to reaffirm its faith in government policy, as it had explicitly started to do in the previous policy. Thus it believes that next year’s fiscal target of 3.5% will be met and this itself will help soothe the possibly inflationary impact of the pay commission.

 

4. It has refused to acknowledge that the lack of transmission on the bond curve and the current market concerns with respect to the liquidity deficit are factors that require any extra attention from the regulator (although the Governor did acknowledge that the heavy auction supply of October may have contributed to yields hardening and this impact should start to fade going forward). Rather, it believes that banks will be able to ensure more transmission on the basis of moving to marginal cost of funds as well as through a focused approach towards asset quality clean up.

 

Going Forward

 

Over the past month, bond yields have been visibly disconnected from the underlying macro-dynamic (both local and global) and instead been bothered about the weak absorption of the incessant auction supply. To that extent, and given that liquidity deficit is close to INR 1 lakh crore in what is an easing cycle with the central bank focusing on transmission, participants were hoping for some guidance on liquidity management from the RBI. Most explicitly, an indication towards bond buy back from RBI would have met with cheer since it would have solved the supply absorption fatigue as well as the extreme liquidity deficit at one go. As things stand, however, market did not get that explicit comfort it was looking for and in that sense may be somewhat disappointed in the near term. However, the gross supply calendar automatically starts to lighten from here on into the end of the financial year. January will be one heavy month for gross supply but will also see new investment from pension/insurance as well as from FPIs on new limit allocation. Thus, the supply fatigue should start to lessen even purely on reducing bond auctions. Furthermore, we would still not rule out action from RBI to plug the liquidity deficit between here and March, especially if the system’s reliance on emergency liquidity window starts to go up.

 

On the other hand, the macro trade remains very much intact and in fact has been strengthened by the RBI today. This is because they have dovishly interpreted the 2 event risks plaguing market sentiment: Pay Commission and GST. On the other hand, global worries that invited the previous 50 bps cut persist and in fact may have got accentuated if the movement in metal and freight rates over the past month are any indication. To that extent, we think the tussle between ‘technical’ supply absorption factors and ‘fundamental’ macro factors is likely to be swing in favor of the latter; especially when considering the abatement of bond supply pressures in the months ahead.

 

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 about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions 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 recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. 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. Neither 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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