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Investment Insights

Suyash Choudhary

Just ‘Coz You See It (Doesn’t Mean It’s There): A Bond Update

 
We’ve been aligned to the idea of a steepening yield curve for some time now. Our chief reasons behind the expectation have been 2 fold: limited incremental visibility of rate cuts, and higher aggregate duration bond supply (including GOI, states, UDAY). This thesis has been tested at points of time during the last year; most particularly when RBI suddenly shifted its liquidity stance and unleashed large-scale bond purchases from the market (thereby challenging our bond supply assumption). However, through temporary disruptions like this and other events (Rexit and Brexit being other notable ones), the underlying trend of curve steepening has remained intact. It has accelerated markedly since September as, presumably, more participants started seeing the prospects of limited incremental rate cuts.
 

While causal commentary on bonds may restrict itself to movements in the 10 year yield alone, it is instructive to see the full extent of the steepening phenomenon that has taken place over the past year or so. This is represented below as the yield differential between 2045 and 2020 government bonds. A portfolio strategy aligned at the right side of this phenomenon has benefited immensely over the past many months. And vice versa.

 

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As can be seen in the chart, the 2045 to 2020 bond yield spread has moved from virtually zero in late 2015 to more than 100 bps now. The intermittent reversals seen in the trend have largely to do with the events described above: RBI’s aggressive bond purchases under its revised liquidity stance, and the period after Rexit / Brexit.

 

Yield curve steepening may be done for now

 

In our view, this dominant trend of yield curve steepening in play over the past year may be done for now. The explicit change in stance in policy stance flagged in the February RBI policy has virtually eliminated all residual rate cut expectations, thereby leading to an aggressive re-pricing of the duration part of the yield curve. Hence, it is likely that yields have largely adjusted to the reality of no further rate cuts from RBI. Also, aggregate bond supply has been higher largely owing to state and UDAY bonds. While we fully expect state bond supply to be higher than last year, seasonally supply on state loans picks up over October – March. This is presumably because the extent of state budget slippages only become apparent towards year end. Thus the next 6 months may be nowhere as busy on state loan supply as the 6 months (and especially the quarter) just gone by. Also crucially, the UDAY program was supposed to run till March 2017 and bond supply in this connection is mostly over. Hence, from the perspective of aggregate bond supply as well, the curve steepening theme is likely to take a breather. Finally, the global ‘reflation’ trade seems to be taking a pause as well. This is most notably getting demonstrated in incremental anchoring of US long end rates and fall in breakeven rates. If this were to continue, then it could constitute another reason for no incremental steepening of our own curve.

 

Risks to this view include an early resurgence in inflationary pressures either locally or globally.  It must be also be noted that the view expressed here pertains only to the near forecasting horizon and some of the triggers mentioned here may indeed not hold later in the year.

 

In line with this view, and as highlighted in a recent note (please refer “Steady As She Goes : A Fixed Income Strategy Update”, dated 15th March, 2017), we have added duration in the 10 year segment largely via spread assets (state loans, UDAY, corporate bonds) in our bond and gilt funds. Most of these bonds have been bought at significantly higher yields than that on long end government bonds, and largely address the same investor class (insurance and provident funds) that the long end addresses.

 

Finally, it is to be noted that the lack of incremental steepening doesn’t imply that short term bonds stop performing or are not looking attractive. Rather, it means that the relative underperformance of the long end versus the short end may not be a sustainable theme any longer over the near foreseeable horizon. Indeed, 2 – 5 year corporate bonds have sold of significantly over March and currently provide attractive spreads over the RBI policy rate.

 

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

A recap of the past few months

 

The past few months have been a volatile ride for bonds in India. Bonds got a powerful tailwind from demonetization fuelled optimism with yields sliding in India even as bonds sold off in the rest of the world on the “Trump reset”. Indeed the potential channels of impact were quite strong for Indian bonds; had they materialized. The initial talked of estimate was for INR 4 – 5 lakh crores to not come back to the system at all. Apart from the fiscal windfall that this would have entailed, it would have led to massive wealth destruction in the system with consequent impact on growth and policy. However, as it seems to have turned out, this effect seems largely to have been absent. The only tangible effect as far as fixed income markets are concerned seems to be a surfeit of banking liquidity and consequent impact on bank deposit rates and, to some extent, SLR demand.

 

By December, policy had shifted markedly in favor of ensuring macro stability; triggered by global developments. For the central bank this translated into reinforcing commitment to achieving 4% CPI inflation sustainably but in a calibrated manner. For the finance minister, it meant presenting a conservative fiscal deficit target despite clear pressures. However, bond market for the most part ignored these developments till the RBI Governor explicitly reiterated the ‘new mandate’ by shifting policy stance to neutral.

 

Bond yields have re-priced aggressively over the past month. The 10 year bond is reflecting very little of the story, since it is in short supply. A better representative is the actively traded 13 year segment which has retraced by more than 60 bps since the day of the February policy. The move has been supported by global developments, where the so-called ‘reflation trade’ has found further support lately; also reflected in further steady rise in yields. An additional aspect of local market dynamic is a very concentrated supply of ‘spread’ assets via UDAY, SDL and corporate bonds over the month of March. This has caused a further reset upwards of yields on these assets. Yields are touching almost 8% on an annual basis on a host of such assets; which are otherwise AAA/quasi sovereign.

 

A portfolio update

 

We had elongated maturity sharply in our income, dynamic and gilt funds in November to play the demonetization move. However once it was clear that gains from the exercise for fixed income were nowhere close to what was initially anticipated, and triggered by a hawkish RBI and Fed in December, we had steadily pared down duration across our funds. Indeed, the December hawkishness from RBI had been reiterated in a speech made by the Governor in January. As a result, and basis context of the global environment, we were preparing for a bottoming out of the interest rate cycle. This was reflected in the very conservative portfolio maturities that we carried into the February RBI policy.

 

Our portfolio approach over the past few months has been informed by 2 sets of triggers: One, given massively excessive liquidity post demonetization we expect bank deposit rates to be muted at least till Oct – Dec 2017. For this reason, we have expected shorter end rates to be well anchored. Whereas, we expected longer end rates to suffer from the twin pressures of no incremental rate cut expectations as well as a reasonably centre plus state bond supply calendar for the year ahead. The net result of this should have been significant yield curve steepening. We are happy to note that this is precisely what has been happening over the past months.

 

However, the extremely crowded supply of ‘spread’ assets (quasi sovereign / AAA) over this month has provided, what looks to us, as an opportunity. We have used this window to substantially hike exposure in these assets of maturities largely ranging between 5 and 10 years. As a result portfolio maturities of our income, dynamic and gilt funds that were hovering between 2 – 4 years, have been increased to 6 – 9 years. Portfolio yields have also moved up substantially, without any dilution in credit quality. We think such a portfolio should look good in an environment where the overnight rate is almost 150 bps lower currently. Also the yield on these assets is now inching remarkably close to where banks on an average are pegging their incremental lending rates for blue-chip loans. Even though the supply of SDL is slated to go higher over the next year, seasonally supply picks up over Q3 and Q4 for these assets. Furthermore, the UDAY program was slated to run till March 2017 and hence supply on these bonds will be largely over, come the new financial year.

 

The macro rationale

 

A key assumption built into our current strategy is that the RBI is on a long hold; or to put it more precisely market will expect that the RBI will be on hold for the immediate forecast horizon. We think this is likely to be the case, for the following reasons:

 

To recap, in our view the change in RBI stance from October to December policy was triggered by the need to anchor macro-stability in context of heightened global risks. A large reason for this escalation in global concerns is around the ‘Trump trade’. There seem to be 3 distinct aspects of the Trump trade:

 

1. A net fiscal stimulus that, ceteris paribus, leads to a tighter Fed policy.
2. A net tax incentive that encourages offshore flows back into the US.
3. A restructuring of trade and geo-political equations of the US with the rest of the world.

 

The first 2 are potentially associated with a stronger US dollar and, in some scenarios, possibly higher US rates. Whereas, the 3rd would get associated with a reduction in the growth stock of the world and an incrementally more dovish Fed. What may matter eventually is the net effect of these policies, provided of course that there is follow through on all these expressed intentions. From an India perspective, we have withstood lower interest rate differentials versus the US over the 2003 – 8 period. With inflation differentials of the order of 3% , the current rate differential may be imminently defensible. Indeed, it may even withstand some compression. However, what matters is that the USD/INR should also remain contained. On this count, the recent record is very admirable with the INR strongly holding its own. Indeed the recent state election outcomes have further strengthened India’s perception on political stability which combined with prudent policy making and reasonably well contained inflation, fiscal, and current account, should further buttress INR’s stability. And so long as INR is stable and India doesn’t suffer a risk from financial flows reversing, the RBI may be content with its current stance over the foreseeable horizon. Risks to this view may come in the form of a disruptive further rise in the USD, potentially arising from the outcomes of one or more aspects of the Trump policy mentioned above. An additional potential risk could be local, if CPI rises faster than currently expected.

 

Given the above, in our view, a portfolio of intermediate duration that focuses also on ‘carry’ may be the best positioned in this environment. Our recent strategy modification is aimed at doing precisely this. As always, and in line with our active duration stance, we will endeavor to reposition our portfolios as and when our assessment of macro-policy / environment undergoes further updation.

 

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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