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Investment Insights

Suyash Choudhary

Introduction

 

Bond markets have struggled to find their feet for most of the last 3 months. A series of triggers have contributed towards this lack of risk appetite. The global environment, most chiefly the recent sharp rise in oil prices, has definitely contributed. However, as we had detailed in a recent note (please refer “The Three Wishes Of The Bond Market”, dated 8th November), there have been three domestic obstacles as well that have contributed to the recent sharp rise in bond yields. These are: RBI’s commentary, OMO bond sales, and fiscal uncertainties. From a probability standpoint, we had opined that there is very little chance that RBI’s commentary turns. We had ascribed an even likelihood of OMOs stopping soon given the crowding out they were causing and RBI’s own assessment that excess liquidity in the current environment is largely non inflationary. Finally, we had assessed that although prospects of fiscal slippage are real, the extent of it is perhaps better defined now given the finance minister’s own expressed intent of adhering to the glide-path.

 

One Wish Granted

 

As things have turned out, and to the market’s immense relief, the RBI has indeed chosen to cancel its latest scheduled OMO. This has been generally interpreted as a yield signal from the RBI and has led to a large relief rally in bonds. Our view (hope) on this is more general and in line with our previous thinking: that it may have finally come to RBI’s realization that the OMOs are an instrumental reason for the crowding out of the market and hence they have chosen to take a bit of a backseat for the meanwhile. The visible liquidity surplus at the headline level is also now well contained although had this been the primary reason, then RBI would have not announced the latest OMO rather than cancel it post a substantial market sell-off. If indeed OMOs are off the table for now, then this takes away a large avenue of excess supply for bonds and, ceteris paribus, should arrest the free fall that bond prices were in and even shift the trading range on yields a little lower. Equally importantly, from our portfolio standpoint, it removes supply from the 4 – 9 year segment of government bonds. As discussed before, we are the most overweight here and valuations between 80 – 125 bps over repo in this segment indeed look quite attractive.

 

The other recent development, that failed to generate any sustainable excitement from bonds, was India’s sovereign debt upgrade by a notch by Moody’s. Admittedly, this did not alleviate any of the current pains of the bond market, given that foreign institutional investors are almost full limit on local bonds. However, there could be some implication here for the tone of RBI policy. It can be argued that there is little reason for incremental hawkishness from RBI given this development. If the central bank were to interpret its mandate in the broadest sense, it is to ensure financial stability. The CPI target is a tool to ensure this end objective of financial stability. Now, to be clear, there is no case to made that the RBI ‘go easy’ on this mandate. However the element of additional hawkishness that had crept in recently, owing possibly to risks to financial stability that the central bank saw in context of potential developed market (DM) tightening, can potentially be dialed back. Of course, this is so long as the RBI broadly believes its own medium term CPI target. However, from a portfolio strategy standpoint, this is not something we will bank upon. To reiterate, the focus remains on finding absolute value under a view that the repo rate remains unchanged for an extended period of time.

 

Conclusion

 

There is a tendency to double or triple discount the same news in the market. Thus risks around fiscal and oil seem to have been flagged continually over the past 35 bps of sell off. Two points need attention here: One, market yields are at these levels because of some headwinds to the market. So it is not enough to keep lamenting these headwinds at every level of the market. Rather, one has to be clear on what the issues are. As discussed above, the assumption clearly already is that there are no further rate cuts. Bond valuations, at least on parts of the curve, are sufficiently attractive for the market not to need a rate cut. Rather the question is whether adverse macro developments seen so far can merit a rate hike. We believe this is clearly not the case given RBI’s own medium term CPI forecasts and the stage of the domestic economic and credit cycle. Two, one needs to be clear on the ramifications of the fiscal concerns that are doing the rounds: A slippage may push back prospects of a rate cut, but we aren’t assuming any cuts to begin with anyway. However, it may also lead to higher bond supply. If this is substantial then it will indeed be a cause for worry. However, if it is only worth a couple of auctions extra then market may tend to take it broadly in its stride. As a case in point, the market has absorbed INR 90,000 crores of OMO bond sales from RBI. This is equivalent to what the government would have borrowed extra had there been a 0.5% expansion in fiscal deficit fully financed via market borrowings. Thus the fact that OMOs are likely to stall from here should at least partly serve to offset any concerns around fiscal slippage.

 

To reiterate from a portfolio strategy standpoint, the environment is more of value picking parts of the curve under an assumption that the repo rate doesn’t change for a  longish time; rather than one of sustained market momentum. However, there seems to be little here that suggests the kind of market breakdown that we briefly saw over the past few days. There is also enough here to keep investors interested, especially given the levels on alternatives including bank deposits and tax free 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 yields have been on a one way street over the past few months on the back of multiple worries of market participants. Post the recent adjustments, valuations on a standalone basis look fairly compulsive especially since the macro-backdrop for rates doesn’t argue for any large reset given: 1> anemic credit growth, and 2> inflation still expected to average at benign levels even post the recent pickup. Indeed, as we have noted before, another 20 – 25 bps rose will put rates in many market segments at equal to or higher than banks lending rates.

 

There have been largely 3 sets of factors that have led to this substantial rise in local bond yields. To put conversely, there are 3 sets of factors that need to unwind for the market to fully go back to levels it was at 3 months back. This line of thought is not pure whimsy; it actually throws up interesting insights when one is hunting for value on the current curve.

 

The Three Wishes
 
The 3 issues for the market, and hence the 3 wishes that the market has, are as follows:
 
1. The RBI’s commentary: As observed here before, it is not so much the lack of the next cut that is bothering the market. Rather, it is largely the commentary emanating from the RBI and more generally the MPC, that has been of concern. Thus despite a medium term inflation forecast that is very close to its 4% target (ex of central HRA), the RBI seems quite hawkish in its commentary. Also, after having guided commentary around real rates a year back, there is no consistency now in even measuring the real rate, let alone guiding appropriate target bands. Put another way, there are 3 main tools that a central bank uses for monetary policy: policy rates, liquidity, and communication. It can be argued that the central bank is actually trying to tighten policy already via its communication / guidance. This would not jar as much if official CPI forecasts were higher or if the central bank wasn’t still insistent on guiding bank lending rates lower. The other more benign interpretation of course is that the RBI is simply not using communication as a tool. If it is not, then it is clearly not operating with a complete tool set; in our view. Thus, the first wish of the market is for RBI to clarify its commentary.
 
2. OMO bond sales: After initially having expressed some reluctance in using OMO sales, given their potential for disrupting bond yields, the RBI has proceeded to sell almost INR 1 lakh crores of bonds to the market. Had this been done by states or the centre as extra borrowing, the negative impacts on yields and potential for crowding out would have naturally been flagged. Of course, the same issues hold when the central bank itself does the selling. Thus there has been upward pressure on bond yields as markets have adjusted to absorb this sizeable supply from the central bank. On an average, the maturity supplied via these sales is between 4 and 7 years.  As a result even this part of the curve has risen substantially. Hence, the second wish of the market is for OMO sales to stop for fear of crowding out genuine borrowing requirements.
 
3. Fiscal uncertainties: Around a couple of months back, rumors arose of a ‘fiscal stimulus’ being planned by the government in order to arrest the slowing growth momentum. Even specific figures of an INR 50,000 crores expenditure stimulus were circulated by some in the media. This was obviously a large spanner in the works as far as bond sentiment was concerned. The stimulus would not only have resulted in higher bond supply but would also have resulted in RBI turning up its hawkishness. However, since then there has been some clarity on this. First, the ‘stimulus’ largely is via below the line recapitalization bonds for banks with no obvious implications for headline fiscal deficit. Second, if there is a slippage it will largely be on account of revenue shortfalls and not additional spending. This clearly then has no implications for RBI. Third, the finance minister has indicated that even if there is a slippage, the government will adhere to the glide-path of consolidation. Hence, it is unlikely that the deficit this year widens to more than 3.5%.  Monthly fiscal data shows some expenditure compression lately, and supports this statement of intent. Thus while prospects of slippage exist, and indeed the last quarter’s borrowing program has been intentionally kept light presumably to be able to accommodate more supply, the extent of slippage is now better defined. Nevertheless, the third wish of the bond market is for more fiscal certainty.
 
The Likelihood of Wishes Coming True
 
We examine below, in the same order as above, the likelihood of fulfillment of the bond market’s 3 wishes:
 
1. We think there is very little chance of any meaningful turn in RBI’s commentary. This is especially true now with the recent upward pressure on crude prices. Thus, we don’t assign any substantial possibility that RBI commentary will lead market to build back expectations of the next rate cut. Thus the working assumption here is that the market expects overnight rates to remain at current levels for an extended period of time. Implicit here is also an assumption that the MPC (ex of Patra) will not argue for any rate hikes for the foreseeable future. We are quite comfortable making this assumption.
 

2. Basis domestic factors alone, RBI should be nearing an end to its OMO sale program. In our estimate, the headline liquidity currently (not accounting for MSS outstanding but including government balance) is around INR 1.75 lakh crores. Given that the government will also roll over balances into new financial year, and accounting for seasonal ‘busy’ season trends in currency in circulation, liquidity should comfortably be under 1% of net demand and time liabilities of banks by year end. However, the calculation becomes uncertain if one considers the dollar flow as well. Thus the RBI has a USD 30 billion plus forward dollar book and more are expected to be coming in the rest of the year. Thus OMOs may continue if RBI wants to neutralize part of its forward book as well. Given that no reaction function has been clearly defined here, the quantum of future OMOs will remain uncertain. However, there is an even likelihood that most of them are done; especially if the RBI starts taking into account the crowding out this is doing for other genuine borrowing requirements. This is especially true since the RBI’s own analysis suggests that the excess liquidity in the current environment is largely non-inflationary given lack of a robust multiplier.
 
3. As discussed above, the extent of fiscal uncertainty is clearer now. Should the government choose to finance this slippage through other sources like for instance reducing the extent of bond buy-backs this year, then the market can actually get a pleasant surprise on government bond supply over the last quarter of this year.

 

Implications for Portfolio Strategy
 
In summary then, we think one has to work with the assumption that the current policy rate holds for the foreseeable future but with an even chance that the government bond supply shock from OMOs and extra centre borrowing in the months ahead doesn’t turn out to be as bad as feared. Given this dynamic, parts of the yield curve stand out to us as offering strong absolute value. Our preference is to be overweight bonds in the 5 – 10 year segment on the sovereign curve. Term spreads here are anywhere between 75 – 125 bps over the repo rate. This is more than enough compensation for a scenario where RBI is on a prolonged hold, in our view. Should OMOs abate, there is a strong likelihood that yields here correct as well. Since our last portfolio update, yields have backed up further and we have used this opportunity to deploy cash in our funds in largely this segment of government bonds. On corporate bonds rates up to 3 – 4 years look good in our view, given that 1 year rates are likely to be well anchored in a backdrop of muted credit growth and adequate liquidity. As before, and over and above our core portfolio strategy, we may look to deploy tactical ‘beta’ from time to time depending upon market scenarios.

 
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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