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Investment Insights

Suyash Choudhary

Expectations in the bond market with respect to incremental RBI rate action have been very volatile over the past few months. The RBI provided a rude shock in December by almost an about turn in its stance from October. Presumably this was done in anticipation of prospects of heightened financial volatility on the back of the so-called ‘Trump trade’. Since then the RBI has been largely consistent with its hawkishness, officially changing its policy stance to ‘neutral’ in February and then hiking the reverse repo rate in April. We have previously argued that both these measures were largely operational in nature and have provided little additional information as far as RBI policy is concerned. Nonetheless, the hawkish rhetoric has been continually up-scaled with an RBI member of the monetary policy committee (MPC) even suggesting the desirability of a pre-emptive rate hike in the April policy.

 

Market participants were justifiably spooked by the suggestion of a pre-emptive hike. We had argued then that there was very little fresh information here, just as there had been little fresh information since every policy after the December one (please refer “Reviewing Our Fixed Income Framework For Recent Developments” dated 24th April, for details). Our conclusion then was that, irrespective of the hawkish minutes, we don’t see a rate hike from the RBI over the foreseeable horizon.

 

Over the past couple of weeks, we sense the needle shifting the other way. From a position of being concerned about rate hikes, there seem to be some nascent expectations building for a rate cut later in the year. The obvious trigger for this is the massive undershoot in recent and next few months’ forecast on CPI inflation versus RBI’s near term expected trajectory. Thus while RBI expects 4.5% average CPI for first half of the financial year, market expectations basis recent data is tracking closer to 3%. Further helping the expectation is a substantial set-back to the Trump fiscal plan, given recent headwinds to the administration.

 

In our view, however, the bar for a rate change (either cut or hike) by the RBI is substantially high. Thus it is probably prudent to ‘fade’ excess bullishness in this environment, just as one was happy to also not accept extreme bearishness post the last policy minutes.

 

The bar for a rate cut

 
1. Current CPI readings, while will definitely flatter the averages for the current year, are not providing as much information about future inflation. This is because there is considerable ‘noise’ in the current readings. Core CPI and perishables are showing a welcome fall, but there is potentially still an element here related to demonetization. While re-monetization is ongoing, we are still more than INR 3,00,000 crores short on currency in circulation from where we were pre-demonetization. Further pulses inflation is negative double-digits owing to the massive disinflation that has happened here on the back of a bumper harvest. However, the price signal has been somewhat false as the tepid actual realization by farmers (below MSP in many cases) might prompt a shift away in cropping in the time ahead. Furthermore, rural wages and MSP seem to be on a steady uptrend which may warrant some caution down the line with respect to average CPI. Government measures like housing for all, while key to uplifting the general welfare of the people and hence an unarguable positive for the country, may shrink labor pools available for agriculture overtime and may steadily set wage floors higher. Hence while RBI may be steadily over-estimating near term inflation prints, it may be getting little information on medium term prints from these and hence may find it difficult to respond to these undershoots.
 
2. In our view, a significant reason for RBI’s sudden shift in stance between October and December was the prospect of heightened global financial volatility, with the obvious catalyst for this being the so-called Trump trade. We have discussed aspects of this trade before. In summary, a new fiscal stimulus over an economy already growing at trend could have lifted inflation and forced the Fed to act faster than usual. Thus RBI was prudent to shift focus towards macro-stability, as did the finance minister when he presented the budget. For the central bank this entailed shifting commentary towards achieving close to the mid-point of 4% of the CPI target range on a durable basis in a calibrated manner. Now as is well known the Trump trade is experiencing significant headwinds for now, and hence the associated fiscal agenda also is at least temporarily on the back-burner. However, this by no means implies that the agenda has completely dissipated. Indeed, there seems to be broad Republican support on getting something done over the course of the year ahead; even as the counters of what may eventually go through may differ from Trump’s initial plan. Also, while there is some rolling over on hard data, there seems to be general consensus that the underlying economy continues to grow well, whereas the unemployment rate is now at the level that is broadly consistent with long term equilibrium. Across the ‘pond’, the Euro zone has picked up pace as well with dissonance amongst ECB members on future course of policy now plain to see. Indeed, there seems to be a reasonable view building that the ECB will soon signal a taper to its balance sheet program. The point here is that while near term developments on the so-called global reflation and the associated Trump trade are sanguine, there is still enough reason to not write them off completely. Thus, from RBI’s perspective, it is still prudent to remain watchful for prospects of heightened global financial volatility, possibly later in the year.
 
3. Finally, the important point to note in this regard is that RBI policy is fairly loose currently, even though currency strength may have caused some incremental financial conditions tightening . Thus for all the talk of a neutral liquidity stance, the central bank so far has been extremely patient as far as draining out the demonetization related liquidity is concerned. Thus even today almost INR 3,50,000 crores of liquidity is sloshing around in the system. Indeed, the RBI had clarified in the last policy that they may want to use variable reverse repo only for demonetization related liquidity; thus implying a long rope for neutralizing this liquidity. As a result of these, bank lending rates for incremental loans have finally seen very strong transmission. Hence, while from a commentary standpoint it may appear that the RBI is ‘getting it wrong’, in actual fact it has kept the money market system extremely lubricated; thereby even ensuring a cycle low point in bank lending rates. So if comfort with respect to CPI improves, the central bank may merely be more content with leaving this liquidity as it is, instead of assuming any sort of an action bias on rates.
 

The bar for a rate hike
 

Even though at this juncture, given the new found sense of optimism amidst market participants, there may seem no merit in even discussing this argument; it is helpful to put the case out since it has important bearing on the future decision making of investors. However, given that this is currently out of context we will keep the arguments brief. Put simply, even when the current cycle turns it won’t be accompanied by the kind of ‘heating up’ in macro aggregates that typically accompanies a normal cycle turn. Rather any turn to the cycle is likely to be triggered owing to the new reaction function of the RBI and most likely in context of prospects of heightened global financial volatility. Thus any rate hikes in the future  will, in all likelihood, come not because we have an inflation ‘problem’ but because the RBI now wants to keep CPI in a much tighter band than before. This would mean not only that the bar for the first rate hike is high, but also that the path of all subsequent rate hikes will be quite shallow. This is very important for investors to remember, should the debate swing back to fear of rate hikes.

 

The implication for investors

 

We have been comfortable with the idea of yield curve steepness over the past year. This has helped our portfolio strategies as the curve has indeed steepened, and substantially. Over March of this year we had also called for a temporary halt to the steepening trade; although it is likely that the trend resumes over the medium term (please refer ‘Just ‘Coz You See It (Doesn’t Mean It’s There), dated 24th March for details). In line with this view, we had also enhanced duration in our bond and gilt funds chiefly via 5 – 10 year spread assets. This has been a good tactical trade and we have booked profit on a substantial holding in SDL / UDAY and moved this position to underlying government bonds. We continue to like the maturity range of 5 – 10 years for now, and will reassess the view down the line.

 

For investors, it is important to fade the noise with respect to potential rate changes from RBI (cut or hike) and focus on a fundamental underlying point: that the yield curve today is steep enough to provide lucrative ‘carry’ and hence offers adequate protection against any sort of  a moderate rate hike cycle that one may potentially encounter down the road. Thus there is more than a 100 bps spread between overnight and 3 year AAA rates. This carry buffer provides, in our view, adequate protection against any modest rate hikes that the RBI may potentially contemplate later on in the cycle. Conversely, the prospects for any sort of meaningful rate cuts are also quite low, and may not be worth chasing for investors.

 

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

Introduction

 
The credit funds’ industry has grown rapidly over the past two years, even as the average credit rating of instruments held in most of these funds has steadily deteriorated. From a manufacturer’s perspective, this may be explained by a constant pressure ‘to dig deeper’ as spreads shrink and still a certain portfolio yield needs to be defended; in the face of ever rising investor flows. However, what we are more interested in here is in examining the investor’s perspective, with the question being this: how is the investor risk perception of the product class turning increasingly benign, even as the actual construction of the product itself (at least as denoted by average instrument rating) incrementally turning riskier?

 

Both credit and duration involve taking a ‘view’

 

To start off, it is worthwhile to examine what drives the construction of each kind of strategy: credit and duration. At a principle level, they aren’t very different. Both strategies aim to benefit from market’s current mispricing of future expected trajectory. Thus a credit manager is essentially expecting a better net return, adjusted for any potential downgrade/loss given default than AAA/sovereign. Put another way, the manager’s view is that market is exaggerating the credit spread on offer by assigning a higher risk of downgrade /loss given default than what the manager’s analysis suggests. This call is not very different from that taken by a duration manager. In this case, when the manager goes long on duration, the view is that rates will fall. Or in other words, the manager’s view is that market is exaggerating the risk to interest rates compared with what the manager’s analysis suggests.

 

Thus it is readily seen that both sets of risks involve taking a view by the manager. The point is obvious and yet seems not always apparent when one looks at investor behavior. We say this since there seems a much more acute sensitivity to potential for a wrong view damaging returns in duration, than it is on credit. Indeed, in many cases there is outright denial that there is any element of view taking in credit (and hence potential for view going wrong); with these funds being called ‘accrual’.

 

A ‘deviation from view’ reflects immediately in duration; not so in credit

 

The market for duration (AAA and sovereign for most part) is much more liquid and hence offers much better price discovery than the market for credit. Thus, for instance, government bonds do tens of thousands of crores of volumes a day. Whereas, there may not be a single secondary market transaction in many of the credit names held by mutual funds. Hence, as an example, if yields on AAA/sovereign rise for a day, the end of day NAV of duration funds will show this movement. However if a credit begins to deteriorate in quality, the spread on this over AAA will not begin to gradually adjust upwards; as should be the case in an ideal world. Rather, the value of this instrument will suddenly deteriorate at some point in the future; most likely post a rating action on the credit. And as we have seen before, this many times involves a multi-notch downgrade of the asset and corresponds with a very sharp deterioration in value of the instrument and hence the NAV of the fund holding this asset.

 

On the face of it, investors should be much more comfortable with a fund where the daily NAV reflects most of the risk that has been incrementally built up during the day. This is very important since then there is reasonable assurance that a new investor coming into the fund is buying in at a price point that adequately reflects all risks that are currently there in the fund. However, quite convolutedly, there seems to be enough evidence that investors have actually preferred a more stable NAV profile, without almost ever asking the question whether changes in NAV are adequately reflecting the changes in the underlying risk profile of the fund. If one thinks about this for a moment, an existing investor may indeed want their returns to be stable. But why should new investors accept an entry point that may not be fully reflecting the true value of a fund’s investments?

 

So far we have established 2 key points:

 
1. Both credit and duration involve the same principle of view taking. Both hence carry the risk involved with views going wrong either in the short or the medium term. However, investor behavior still suggests that while risk of erroneous views associated with duration are well understood, the same with respect to credit is as yet quite underappreciated. Indeed, at most places, the funds themselves are denoted as ‘accrual funds’; thereby lending an implicit assessment that these funds are mostly just carry products and offer no real risk. The impressive growth in the credit fund category over a relatively short period of time in the Indian fixed income context which has inherently fixed deposit investors, also suggests that this is indeed the case.

 
2. NAV volatility merely reflects a better discovery of underlying portfolio risk and hence provides a much better price to investors for investing in the fund. And it is beyond argument that price discovery is much better in sovereign / AAA. Yet, the preference seems to be for less volatility in NAV. Seldom is the question asked whether the less volatile NAV truly reflects the underlying changes in risk to the fund. It is to be noted that, in most times, even long term investors worry about near term volatility in NAVs. A simple thought experiment that proves this point is this: Tax free bonds may have maturity of 15 years but are considered safe, assured long term investments that give coupon every year. This is irrespective whether the value of the bond is constantly fluctuating in the secondary market. So long as the investor doesn’t look at those fluctuations, the perception stands. However, hold the same investment in a mutual fund that publishes daily NAV, and the perception of risk may change drastically.
 

This then brings us to the last point we want to make here:

 

The myth of net portfolio yield

 

The yield curve in India is largely positive sloping. This means, for example, that you will make higher yield on buying a 10 year corporate bond than when you buy a 2 year corporate bond. On the AAA curve, the gap between the two is approximately 40 – 50 bps. And yet, investors today are preferring short term funds (proxy for 2 year bond) over income funds (proxy for 10 year bond). Why do investors choose to lose this excess carry and are still preferring the 2 year bond today?  The question is largely rhetorical since, as we all know, the answer is obvious: investors expect that the interest rate cut cycle is largely over and hence they don’t believe long passive duration is likely to perform over the next few years. Put differently, investors understand perfectly that chasing the last 50 bps may not be worth it if it involves taking higher amount of duration risk. However when a credit fund is offered with the exact same trade-off, higher portfolio yield with higher corresponding credit risk, most investors are willing to accept the higher risk.

 

On the face of it, this seems to be very inconsistent behavior. However, if one were to examine this behavior alongside the point we made about NAV volatility above, then it is more readily understandable. Most investors only consider realized  NAV volatility as risk. They don’t consider the prospects of future potentially unacceptable NAV volatility if: 1> the NAV they are buying into today doesn’t appropriately capture the risk currently embedded in the fund; and / or 2> they are deviating considerably from their inherent conservative risk profile.

 

To put it differently and succinctly, investors are happy to control for duration risk when deciding how much carry they want. However, they don’t control for credit risk when making the same decision.

 

Conclusion

 

To re-emphasize, the intent here certainly has NOT been to pitch duration against credit. Rather, it is to bring out certain aspects that, in our view, are relevant when investors look at each respective asset class. It is also to try and establish that certain aspects that provide comfort (lack of NAV volatility for instance) may actually be doing so falsely thereby distorting investment decision making behavior and potentially sowing the seeds for unacceptable return volatility down the line. Finally, it is to make the case for risk segmentation even when selecting credit funds; just as a similar segmentation is done when selecting duration funds.

 

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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