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Investment Insights

Suyash Choudhary

RBI Governor Urjit Patel, when he was deputy Governor under Raghuram Rajan, had once famously said that RBI is neither a hawk nor a dove, but an owl. As explanation he had offered that an owl is traditionally a symbol of wisdom and that owls are vigilant when others are resting.  He couldn’t have put the role of a central banker more aptly. Indeed the analogy can helpfully be extended to bond investors as well, who have to be mostly perforce be classified into either doves or hawks. Whereas, what is infinitely more valuable in our view than a natural bias towards the market (that is bullish or bearish) is the existence of a robust framework with which to evaluate the market and keep updating this framework for incoming information. Such an approach would have served quite well over the past year in bonds, which has been marked with significant noise and related market volatility.

 

A brief history of RBI
 

Since October of last year, almost every monetary policy meeting has turned out to be quite eventful for the market. Amongst these the most noteworthy have been perceived to be the February one (where the RBI officially changed stance), and the April one (where the minutes came out to be substantially hawkish). In our view, however, the December policy was the one where the RBI had actually changed tone and subsequent ones were largely operationally reaffirmations of this tone. There was a marked contrast between October and December policy events. While the former was arguing for the possibility  of a lower real rate target for India, the latter brought focus back on the need to bring CPI closer to 4% on a sustainable basis. And to us the only large event that could have triggered this hawkish switch (demonetization was a dovish event for monetary policy) was the political change in US and the prospects of heightened global financial volatility owing to the associated economic policies of the new administration. However it was clear by March that the momentum around these promised policies had dissipated. This was most evident in the reversal of the dollar and the re-igniting of financial flows back into emerging markets. Quite helpfully, the Indian bond curve had started pricing in lack of rate cuts. These provided us with both the opportunity and the trigger to build back duration in our bond and gilt funds.

 

With the Trump trade in steady remission, and the RBI seemingly overestimating near term CPI, we had argued in April against fears of a rate hike (please refer “Reviewing Our Fixed Income Framework For Recent Developments”, dated 24th April for details).  The pendulum now has swung in the other direction with the central bank now dramatically revising downwards its CPI forecast and minutes of the June policy showing a vocal break in rank with at least one monetary policy committee (MPC) member. Bond markets smell rate cuts again with market expectation now inching towards a 50 bps cut over the next few months.

 

Recapping what we know
 

There is no doubt that the underlying environment is bond bullish. The first trigger for this was a turn to the Trump trade that substantially diminished prospects of global financial volatility and rekindled strength in emerging market flows and corresponding currencies. Added to this has been the turning over of hard data in economies like the US and the noticeable fall in prices of global commodities. Indeed, the US yield curve has flattened aggressively and seems to be actively challenging, at least for the time being, both the validity of the Trump trade and the Fed’s thesis that lower unemployment rate will cause inflation to rise down the line. Against this backdrop, our local CPI is significantly undershooting expectations causing the RBI to sound tentative with respect to its earlier hawkishness.

 

The only point of debate then is how much aggression, if at all, to ascribe to the RBI’s incremental reaction function. It is to be remembered that most of what RBI has ‘got wrong’ lately is largely with respect to its commentary and forecasts; not necessarily its actions. Indeed, a significant change now from most of the Rajan era of rate cuts is the practical stance on liquidity. While in theory RBI is targeting neutral liquidity, they have so far displayed remarkable patience with the demonetization related liquidity glut that has now persisted for more than 6 months. Indeed, this could possibly be the main reason why one doesn’t hear too many bankers clamoring for a rate cut anymore. It will be remembered that when RBI was cutting rates while keeping liquidity tight, bankers were quite vocal in saying that they need liquidity more than rate cuts.

 

It also has to be appreciated that the RBI’s tentativeness now is to a large extent justified. As it has maintained since December, it wants CPI to average closer to 4% on a sustainable basis. The current CPI prints contain substantial noise. The starkest takeaway is that the current farmer realization on selling crops and vegetables is apparently causing substantial unrest in many places. Apart from political dynamics of the issue, the spate of farm loan waivers currently getting announced seem partly to also attend to this unrest. It is therefore nobody’s case that the current food inflation can be extrapolated into the future. So there may be little information for RBI in the current aggressive disinflation in food. Similarly, it must be remembered that there are some discretionary policy choices that we have made which are all unequivocally good for the long term, but which require some growth trade-off in the near term. These include demonetization, GST, as well as the accelerated banking sector clean up that has now started. Thus while growth was already slowing over last year, one cannot excessively lament the larger slowdown now and lay the addressing of this at RBI’s door. This is because even if RBI wants to react to this temporary slowdown, it is well known that monetary policy may be ineffective for this; given that it acts with at least a 2 – 3 quarter lag on the real economy. By that time the temporary disruptions from these policies may already have passed over. In fact, and as noted by Deputy Governor Acharya, the banking transmission channel may be particularly impeded today given asset quality issues.

 

Investor Takeaways

 

To recap, the environment remains decidedly bond bullish given the current dissipation in the US fiscal agenda, a rolling over of hard data and commodity prices, and local CPI substantially undershooting expectations. Within this framework, the debate is on how much more to expect from RBI. Complicating this analysis is RBI’s own current confusion and inability to be able to sift through the noise in the data. Happily, though, investors needn’t be confused at all. Active duration funds should have a long duration bias currently. Our preference is to construct this via a mix of spread assets as well as underlying government bonds. The focus here, though, should be on active duration management and the ability to cut out the excess duration risk later if circumstances change. Short term and medium term funds continue to look good given the still attractive spread between overnight rate and front end bonds.

 

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

Bond market had gone into the current policy expecting RBI to acknowledge its ‘mistake’ with respect to over-estimating its near term CPI trajectory. In that it wasn’t disappointed. Thus RBI’s HI forecast for CPI has been dramatically revised down from 4.5% to 2 – 3.5%. Whereas, H2 forecast has been revised to 3.5 – 4.5% from 5% earlier. However, importantly, the caveat here is that these forecast ranges are only valid ‘if the configurations evident in April are sustained’.  The usual upside risks are highlighted including monsoons, risks of fiscal slippage (largely flagged due to the new emerging trend of loan waivers), geopolitical and financial risks, and allowances under 7th Pay Commission. GST is not considered as a material upside risk to inflation.

 

Growth forecasts are largely static with RBI revising FY 18 GVA estimate downwards by only 10 bps from April 2017 to 7.3%. Continued remonetisation, reduction in bank lending rates, government spending etc are all likely to be supportive of growth.

 

Takeaways:

 
1. The MPC is exhibiting significant uncertainty with respect to the current inflation prints. Thus it talks of lingering effects of demonetsation as well as excess supply conditions with respect to fruits, vegetables, pulses and cereals. It also notes in this context that CSO data suggests that effects of demonetization are sector specific and transient, as well as that private consumption is resilient.. Hence, it is as yet difficult to isolate the one-off factors or judge their strength and persistence. Whereas, the MPC also expects that underlying inflation pressures, especially input costs, wages, and imported inflation will have to be closely monitored. The MPC also notes that headline CPI has been below 4% only since November; whereas the commitment is to keep this close to 4% on a durable basis ‘keeping in mind the output gap’.
 
2. At this stage, given the state of banking system and the existence of infrastructural bottlenecks, the role of further monetary accommodation is anyway seen limited. Hence, the RBI is choosing to focus on these and other non-monetary factors. Thus it has further cut SLR and reduced risk weights on housing in order to improve credit supply in the system.
 

Inferences and Portfolio Implications

 

It is somewhat curious that the RBI has already revised dramatically its forecasts for forward inflation; given all of the risks that it still perceives to this trajectory. While there is a caveat provided to the new estimates of forward CPI (April configurations should sustain), the RBI nevertheless runs the risks of getting blamed now on either side with respect to its forecasted inflation trajectory. That said, the bar for a cut remains adequately high given both the noise in the current data as well as the RBI’s assessment that at the current juncture further monetary accommodation may be useless given other constraints. However, the important thing that this policy has done is reaffirmed market participants view to be biased for a cut rather than a hike. And this by itself is reasonably positive for bonds.

 

Our view remains exactly the same post this policy. We have pushed against fears of a hike post April minutes; suggesting that the bar for action on either side is reasonably high. This holds even when one expects RBI to now move towards a cut. Ultimately, in a CPI targeting regime there is always one constant: if one’s own forward CPI forecast is within policy target ranges one should expect rate cuts; and vice versa. Thus earlier RBI seemed to be over-estimating near term CPI and we, alongside many others in the market, were comfortable with the idea that RBI will have to re-think their trajectory. The same principle applies for the time going forward: if the current suppressed CPI trajectory were to be broadly sustained so that average CPI for the year seems to be comfortably at 4% or lower, then one should expect monetary easing. However, if when the current noise from CPI data dissipates and one realizes that the CPI averages are higher, then this is the end of the rate cycle.

 

From a portfolio stand point we think the largest value is in the spread curve (UDAY, SDL, corporate bonds). While there has been some compression on these spreads over the last couple of months, the absolute yields as well as relative spreads on these bonds stands out. At the time of writing, a 10 year SDL is dealing almost 15 – 20 bps over the long end government bond and some 85 bps over the 10 year government bond. This is a better proxy, in our view, for the long end of the curve, given that the latter is extraordinarily dependent on demand from just one investor. The current environment of sanguine local and global prospects is ideally suited to steady compression of these spreads. Accordingly we continue to run significantly overweight positions in these assets in the 5 – 10 year space. We will revisit this positioning later in the year when we expect yield  curve to renew steepening.

 

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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Arvind Subramanian & Khushboo Sharma

Assessing Credit Funds

By: Punam Sharma

With the rapid growth in credit funds and a plethora of options available to an investor within the category, it is important to understand the parameters on which these funds should be differentiated. Unfortunately, Yield to Maturity (YTM) has become the principal metric by which credit funds are measured. It is commonly believed that higher the YTM, better the expected return and hence, better the fund. As we will see over the course of this note; this metric of YTM, while convenient, is seldom an accurate measure for actual returns.

 

Portfolio YTM is a poor proxy for predicting future returns

 

YTMs of credit funds should theoretically reflect both the change in funds’ underlying credit profile and the broader movement in market rates. However, as we highlighted in our earlier note (refer ‘A Rose By Another Name: Credit and Duration’, 11th May 2017), the strengthening/weakening of underlying credit profile is not always reflected dynamically in the yields owing to the inherent illiquidity in credit markets. Nevertheless, the credit funds’ returns do in fact move in reasonable sync with the broader market. Even though credits are not actively traded in the market, they are valued relative to a liquid benchmark and are accordingly marked up/down, thus capturing daily movement in market rates. This is best illustrated by comparing the return profile of a ‘AAA’ oriented fund versus that of a ‘Mid Yield[1]’ and ‘High Yield[2]’ credit fund over the course of the past year.

 

1

 
Keep in mind that interest rates have been reasonably volatile over the past year and as we can see in the chart above, all three funds have exhibited similar volatility in sync with overall movement in interest rates. In this context, it is rather unfortunate that credit funds continue to be marketed as ‘accrual’ especially since their return profile is not immune to vagaries of the market as is the case with traditional fixed income funds. Here, it is useful to remind investors that the returns of any fund, credit or otherwise, is derived from the following equation:

 

Total return of a fund = Coupon ± Mark to Market gain/loss – Expense Ratio

 
Unfortunately, when it comes to assessing credit funds, investors tend to ignore other variables attributable to fund returns and only instead choose to focus on the headline YTM published by a fund.

 

We have so far established that credit yields are not necessarily static and instead generally mirror the rate movement in the broader market. It is evident from the analysis above that a credit fund would have generated returns, higher than its own running yield, over the past one year via 1) higher average maturity (since overall market yields fell during the course of the year); 2) individual credit selection within the ‘Mid Yield’ or ‘High Yield’ which have outperformed the broader market; and 3) higher/lower allocation to sectors which have outperformed/underperformed. A combination of a few or all of the above would have helped generate returns which are higher than the net YTM of the fund itself. Just as is the case with traditional short term/income funds, credit fund returns are not just a function of portfolio YTM but also a function of maturity profile of the fund and individual security selection.

 

It is also indeed ironical that investors keep chasing funds with higher YTM. This is because, for a static portfolio, if YTM of the fund keeps increasing month over month, the actual returns to a customer would be lower than the running yield of the fund. In contrast, if a fund’s YTM keeps declining (assuming a static portfolio); it only means that investors will be rewarded with returns higher than the running yield of the fund. However, this aspect gets ignored in the market’s continual search for higher yielding funds. What ultimately should matter to investors are actual returns and as seen above, running yield is not necessarily the best indicator for portfolio performance.

 

Illusion of stable NAV is detrimental for investors

 

We have so far demonstrated how credit yields move reasonably in sync with overall movement in interest rates. However, seldom do we see individual credits getting re-priced beyond broader market movement, to reflect their own change in credit fundamentals. History has shown us that sharp movements in yields reflecting a company’s changing credit profile generally occurs only post revision in a firm’s credit rating rather than active price discovery, given the inherent illiquidity in the credit market. This in turn gives the illusion of a stable NAV and therefore the perception of predictable returns. However, it is important to remember that this illusion of a stable NAV is detrimental to investors, especially new investors into a fund who might be assigned a NAV which does not truly represent the price of underlying securities.

 

In the past, we have witnessed instances of sudden drops in NAVs of funds in the event of sharp downgrades of credit ratings of some bonds. An analogy to illustrate this point would be crossing a river with an average depth of 4 feet. This would give the river crosser an illusion of safety and stability. However, it may happen that the average hides volatility; so at the centre of the river its depth is actually 10 feet and at the banks of the river the depth is only 2 feet. Hence, a person crossing the river assuming stable depth would actually run the risk of drowning at the 10 feet depth (in our instance a credit event or a sudden sharp credit downgrade).
 

A case for active management in Credits within the ‘Mid Yield’ segment

 

Just as is the case with traditional short term/income funds, we have seen earlier how credit markets offer sufficient opportunity for funds to generate higher returns than their portfolio YTM via active management. However, this will remain academic unless supported by sufficient market liquidity, the lack of which can severely restrict the ability of market participants to execute views. Unfortunately, most parts of the credit market remain reasonably illiquid with small volumes traded on a daily basis. This is particularly true for the ‘High Yield’ segment which suffers from acute illiquidity. In contrast, credits in the ‘Mid Yield’ segment offer reasonably better liquidity thus allowing for some amount of active management.

 

Given the ability to actively manage credit funds, especially in the ‘Mid Yield’ category due to relatively better liquidity and price discovery, it is possible to generate surplus returns over portfolio running yield.

 

Summary

 

We have in the past made a case for segmenting risk while investing in credit funds. The purpose of this note is to urge investors to reassess their framework for assessing performance of credit funds rather than recklessly chasing funds with the highest running yields. As we have seen above, portfolio YTM while a very convenient indicator for future fund performance is seldom accurate since it ignores both credit risk and market risk. Instead, there is a clear case for investors to look at other aspects of a fund such as the average maturity, rating profile and credit quality of portfolio. As investors have always differentiated between long duration and short-term funds in duration funds or between large-cap, mid-cap or micro-cap funds in equity funds, credit funds should also be differentiated.

 

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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