By: Punam Sharma
A Summary Of The Year Gone By
The year gone by has been a roller coaster for fixed income. Volatility, which has been a word almost missing in other asset classes this year, has been the hallmark for bonds right through. The positive start to the year was soon disrupted with the RBI changing policy stance in February from accommodative to neutral. Bond yields, which were already in the midst of a post demonetization reversal, sold off sharply. The sentiment was accentuated with the minutes of the April RBI policy where one member seemed to even favor a pre-emptive rate hike. Quite ironically, a significant reversal started from this point with CPI collapsing, partly owing to one-off factors. RBI commentary started turning tentative and was ultimately followed with one more rate cut. Simultaneously, concurrent growth indicators appeared to be quite weak with the first quarter GVA print finally triggering a substantial debate over the extent of growth slowdown. Post that one rate cut, however, the RBI remained quite steadfast, focusing commentary on the 4% CPI target. Alongside, an Open Market Operations (OMO) sale program was launched wherein ultimately the RBI issued INR 90,000 crores of bonds to the market. Market appetite for bonds soon got fatigued with excess supply aided by OMOs and with a dwindling risk appetite owing to fiscal uncertainties, rise in global oil prices and continued RBI hawkishness. This started translating into a rapid rise in yields over the final quarter of the year, with risk appetite almost completely breaking down over the last month. The final straw was the finance ministry announcing INR 50,000 crores of extra borrowing for Q4. This was at the pessimistic end of market expectations, especially given the recent assuring noises made around commitment to deficit targets.
The Best Bond Trader
Most bond traders and fund managers have had a very difficult time over the past few months given the remarkable nature of price movement; almost a one way deterioration with hardly any break or respite. In hindsight, the RBI hasprobably been the best bond trader on the street this year! It has managed to sell INR 90,000 crores from its bond book starting at around 6.5% on the 10 year and ending at around 7%. At the time of writing, the 10 year bond yield is almost at 7.4%. Any market participant who had achieved this feat would have justifiably felt very proud of themselves. Obviously, these comments are made partly in jest. However, some underlying points deserve attention. The central bank and its research had said three things that are of relevance for this subject: One, OMOs will be done non-disruptively. Two, the current excess liquidity is largely non-inflationary absent any substantial multiplier accompanying it. Three, bank lending rates still need to come down. Given these, the persistence with which OMOs were conducted seems a little remarkable. They stopped quite remarkably as well with the RBI preemptively cancelling the last announced OMO partly citing market conditions. However, the real break down in market risk appetite started after this, since the cancellation fuelled hopes that more interventions would happen and they didn’t. Also, from a transmission standpoint, it remains a personal mystery to us how the central bank still expects banks to transmit further when even the front end of the risk free rate has risen sharply over the past few months.
Our Thinking Errors Of The Past Few Months
A year end commentary is a good opportunity to also reassess how one went over the year. There are two significant thinking errors that we have committed this year. We started off well after having sold out most of our post demonetization duration positions. The December 2016 policy had amply demonstrated the central bank’s hawkishness and therefore it was no more than a mild surprise to us when the RBI explicitly changed stance in February. Post the yield adjustment in March, we reinitiated a long bias on rates. However, the framework we were operating with from mid-year proved to be flawed. India’s growth had been deteriorating since much before demonetization and despite almost a synchronized recovery in the rest of the world. The after-effects of demonetization only accentuated this trend. Our thesis was that since CPI averages ex of one-offs were now largely around RBI’s targets, the debate may not shift to the appropriate real rate stance that needed to be maintained given the financial stability and growth outlook. The rupee had been consistently strengthening since early year backed by very robust fixed income flows. This was the strongest testimony to the fact that our real rates were very attractive in context of India’s perceived macro-stability status. In fact RBI had quite the task in managing the very strong capital flows that we were seeing. Simultaneously, there was significant deterioration in concurrent growth. Both these seemed to indicate that the time was ripe to re-initiate the real rate debate. Indeed, we were further encouraged in this line of thought when the chief economic advisor expressed similar views in his mid-year economic review; going so far as to flag deflationary forces in the economy. However, as it turned out, the RBI did not express any clear real rate stance, not even a consistent definition on how this is to be measured. Passing references seemed to be adding back the ‘optical’ HRA effect of pay commission that the central bank had previously promised to ignore. Indeed, the focus remained steadfastly on the mid-point of the flexible inflation targeting band of 4+/-2% even as growth projections started to be undershot. Once the October policy showed that our framework was erroneous, we aggressively cut risk in our bond funds.
The other thinking error was very recent. We continue to believe that RBI is very far from an actual rate hike. Faithful to this framework, once we judged that the market was moving into rate hike pricing territory, we started deploying cash. With the large scale market break down that has happened over the past month, all tenors of the yield curve have suffered massively. Our stance of zero cash during this period has obviously hurt. However, given the 50 plus bps rate hike pricing that currently exists in front end bonds, we are comfortably carrying forward these positions. To reiterate, the view remains that the RBI is likely on hold notwithstanding further step up in hawkish rhetoric. There are two risks to the view: One, a substantial cyclical recovery in India that closes output gap faster than currently expected. Two, a significant rise in the US dollar that brings financial stability risks back to the fore.
The Way Ahead In 2018
The best thing starting the new year is that bond valuations seem to be already pricing in a 50 bps rate hike. This is most visible in front end bonds up to 4 – 5 years. Therefore, by definition, the absolute value lies the most in this segment. There are 2 ways to look at this: One, if our view is correct and the RBI is indeed on a long hold then there are substantial mark-to-market gains to be made in this segment. Two, if the view is wrong and there is a further sell off in these bonds, one is still likely to make at least liquid returns from such investments over the year; given the substantial starting spread that these bonds have over money market rates currently. One must also keep in mind that front end rates typically tend to come off over the so-called lean season on credit that runs between April and September. Hence, this looks like a good starting point to invest in ultra short, short, and medium term kind of funds.
As far as active duration bond funds are concerned, we are continuing to consider our 2 – 9 year sovereign / quasi / corporate positions as core portfolio. Spreads here are of the order of 120 – 180 bps over repo, again indicative of stress pricing and offer substantial cushion. Longer duration positions have to be treated more tactically. While so far such tactical trades have only lost money given the one way massive spike in yields, it is likely that they deliver better performance over the next few months now that market may be approaching a zone of stability. At any rate investors should continue to consider active duration funds from a longer term perspective. This is imperative since these are not magical funds that can guard against every bout of market volatility. Instead they are run actively around the fund manager’s macro and market framework. The past year has thrown in both errors of framework as well as a bond market sell-off that is almost unprecedented for a country that is not facing any sort of a macro risk whatsoever and is in fact experiencing sub-par growth. Therefore, to look at last year’s returns and decide for the future may prove to be as fruitless an exercise as any other form of rear-view driving.
Wishing Everyone A Very Happy New Year
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