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Investment Insights

Arvind Subramanian

Liquidity in Credit Markets

By: Punam Sharma

As we have highlighted in our recent notes, price discovery in credit markets involve two key aspects. The first aspect is the movement of bond yields in sync with the broader market. This, we believe, is captured reasonably well since all securities are continually valued relative to a liquid benchmark and are accordingly marked up/down, thus capturing daily movement in market rates. The second aspect, namely credit spreads, is the movement in bond yields due to relative strengthening/weakening of underlying credit profile of the issuer. This is seldom captured dynamically due to inherent illiquidity in credit markets.
 

In this note, we aim to provide an assessment on liquidity by analysing the frequency of bonds trading in the credit market. This is important because sufficient liquidity or lack of it has a bearing on price discovery of credits which in turn determines the accuracy of the daily NAV of a fund. To quantify this, we measure the number of days since last trade of any bond of each company. Higher the number of days since last trade means the bond is relatively more illiquid than one which has traded in the recent past. For the purpose of our analysis, we bucket these into the following time periods- 1 week, 1 month, 3 month, 6 month and Over 6 months. Subsequently, we map individual companies in the credit market to these buckets basis frequency of their trading.

 

Liquidity in credit markets is relatively thin; ‘Mid Yield’ exhibits better liquidity than ‘High Yield’
The relative illiquidity in credit markets is apparent in the chart below which shows the distribution of securities across the various liquidity buckets. For this analysis, we have bifurcated securities into ‘Mid Yield’ and ‘High Yield’ .
 
1‘Mid Yield’ refers to securities in the YTM range of 7.5% to 9.5%. Such securities predominantly belong to the AA- to AA+ rating category.
2‘High Yield’ refers to securities with a YTM higher than 9.5%. Such securities predominantly belong to the AA- and below rating category. YTM for securities is as on 30th June 2017.
 
liquid1

 

As seen above, only a small percentage of securities trade frequently, evident from the lower distribution of companies in the shorter tenure buckets (‘1 week’ and ‘1 month’). In the case of ‘High Yield’ segment, the illiquidity is stark with a majority of companies belonging to the ‘Over 6 month’ liquidity bucket. Overall, it is visible that liquidity is relatively thin in the credit market, within which the ‘Mid Yield’ segment exhibits comparatively better liquidity than the ‘High Yield’ segment.

 

liquid2

 

We apply the same metric to IDFC Credit Opportunities Fund (IDFC COF). In contrast to the broader credit market and even the overall ‘Mid Yield’ segment, the liquidity profile of IDFC COF is visibly superior. As seen above, a significant majority of companies held by the fund trade frequently (higher distribution in the ‘1 week’ and ‘1 month’ buckets).

 

To recap, we believe that investors benefit from investing in funds wherein the underlying securities are reasonably liquid. This ensures better price discovery for such securities and thereby improves the accuracy of the daily NAV, thus providing a fair entry/exit for investors.

 
Data comprises over 300 companies held by the credit fund industry belonging to the ‘Mid Yield’ and ‘High Yield’ segment. For the purpose of this analysis, we have considered trade data from Corporate Bond Reporting and Integrated Clearing System (CBRICS). Inter-scheme trades have been excluded. CBRICS is not necessarily exhaustive, but is reasonably representative of primary/secondary market trades. Subsequently, last trade date/primary issuance of any security by an issuer is considered. YTM for securities is as on 30th June 2017.

 
risko

 

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

 
Prima facie there has been ample to be confused about, with respect to the current bond market. There is sufficient noise both with respect to quantum of expected RBI easing as well as with the data on hand. The two are interlinked in the sense that if data were to clarify itself, specifically on how much of the current disinflation is real and what will reverse, it will provide more clarity both to the market as well as the RBI on the future course of policy action. To recap, the issue with the 2% handle reading on CPI has been that it is backed by aggressive disinflation in vegetables and pulses, which may mean revert down the line. Furthermore, there may be demonetization related disinflation as well which may also not sustain going forward. Adding to the noise are the one-off events of GST and pay commission. All told then there is enough on RBI’s plate and, by extension, on that of the bond market.
 

However, the other way to look at this for investors is that prospects of global financial volatility have settled down, domestic currency is stable and liquidity more than adequate. Further, no matter the semantic, CPI is decidedly undershooting anticipated trajectory. Our preference has been to think of things in this fashion since February / March; once prospects of global volatility had decidedly settled down. Given that impact from GST and pay commission no longer seem as great as earlier thought and items other than vegetables in CPI may take their own time in mean reverting, market’s case for some modest easing at least seems appropriate as well. This of course adds to the benign view for bonds and the bias has to be bullish in an environment like this.

 

So What’s New?

 

All this is nothing new and has been discussed over and over again. The purpose here is to talk about two additional developments and to update on some changes to portfolio strategy. Both the developments have had the effect of near term stalling the bond market rally.

 
The first is global: there is some anxiety lately with respect to hawkish talk from central banks including from the Fed and the ECB; apart from some smaller banks. Thus even with no discernible change in data, some wind has dissipated from bonds in major markets. However, so long as this is not backed by hard data, one shouldn’t be reading too much into this.

 
The second is local: the RBI has announced OMO sale to the market for INR 10,000 crores for this week. The point of debate here is, of course, not just this one OMO but rather how many more to expect going forward. If RBI starts supplying duration to the market via this route on a consistent basis (that is OMOs happen regularly and RBI accepts bids in longer securities as well), then ceteris paribus this does indicate wider term spreads than what one would have expected before. There are two aspects to consider here: First, how many more OMOs would depend upon the net effect of RBI’s spot currency intervention and the extent of leakage of currency in circulation. On the former, it is to be noted that RBI has built a substantial forward dollar book again; this time presumably to neutralize the rupee liquidity effect of its forex interventions. Also, these positions are not maturing in the near future buckets and hence will not require a neutralizing liquidity response from RBI in the next few months. The spot dollar intervention is, of course, more difficult to predict.

 
With respect to currency in circulation, while the next quarter is seasonally one of no net drain; nevertheless there is substantial drain between now and end of year as the first graph below demonstrates.

 

graph05

 
graph051

 

FY 16 had seen a notable increase in currency in circulation over second half with all sorts of explanations, including state elections, on offer for this. However, the substantial drain had never really reversed all the way till demonetization. Should the rest of year drain this year be anywhere close to FY16, this is something for RBI to watch for before implementing any substantial liquidity operations. Also, as the second graph shows, the process of currency restoration is very much still continuing; over and above the normal seasonality in currency data.

 

The second aspect of OMOs is operational: RBI Deputy Governor has repeatedly assured that the tool will be deployed carefully with minimal yield disruption. Also, our sense is that this tool is only being used because the government for some reason is not amenable yet to expanding the MSS issuance ceiling. However, should the requirement for liquidity mop up turn significant, the government may very easily come around to agreeing to raise the ceiling. All told then, while one has to be watchful in this regard, there is as yet little reason to worry on account of OMOs; especially given the underlying benign environment.

 

A Portfolio Strategy Update

 
We have been running significant duration positions in spread assets including SDL, Uday and corporate bonds since February / March. They were available at stress valuations then and have performed well since. However, the trade also had limited period shelf life, given that supply on spread assets rises continually over the next few quarters. Indeed, the Q2 SDL calendar announced recently is more than 50% higher than actual issuances in Q1.

 

In preparation for this, we have been steadily reducing positions in duration (10 year and beyond) SDL, Uday, corporate bonds and switching the positions into government bonds. With this, our exposure in such duration spread assets in our bond and gilt funds is now very little and our preference for the time ahead is to run such duration positions now with government bonds. This will also make flexible duration management easier which may be helpful in the months ahead. However, we continue to like these spread bonds in the 5 – 6 year maturity and below; given the handsome carry that they provide even with respect to corresponding corporate 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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