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Investment Insights

Arvind Subramanian & Khushboo Sharma

Slowing flows into Credit oriented funds
 
It is well known that lower rated credits have low/negligible liquidity in the bond market. This has been further exacerbated in recent months wherein debt markets have seen deteriorating liquidity for even AAA rated corporates. Nevertheless, illiquidity concerns in the lower rated credit space have seldom been at the forefront for credit fund investors due to the near secular inflows into the category. As a result, many perceive these bonds as “Held to Maturity” without needing to worry about associated liquidity to fund redemptions/ price discovery.
 
However, this illusion of utopia, despite relative illiquidity in the credit markets could be set to change with slowing flows into credit oriented funds[1]. The chart below highlights the sharp reduction in flows to credit oriented funds in recent months after several prior months of strong growth. In fact, in May 2018, net monthly flows into credit oriented funds were at its lowest since February 2016.

 
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(Source: CBRICS, ICRA MFI Explorer)

 
Time to refocus on liquidity in credit markets
 
We have always believed that liquidity plays an important role even in the credit markets as discussed in our earlier note (Liquidity in Credit Markets, 07 July 2017). To recap, we had highlighted the significance of liquidity not just in helping meet redemptions, but more importantly in price discovery of securities. Price discovery ensures better accuracy in daily NAV of funds, thus providing a fair entry/exit for investors.
 
In light of slowing flows towards credit oriented funds, we have refreshed our analysis on portfolio liquidity across various segments in the credit market as seen below. Here, we calculate theLiquidityScore – defined as the percentage of issuers in a fund’s AUM, whose bonds/debentures have witnessed a trade[2]at least once since 1st April 2018, for each fund in the category. Higher the LiquidityScore better is the presumed liquidity in a fund and vice-versa.
 
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In the above chart, a AAA oriented fund like IDFC Corporate Bond Fund has a LiquidityScore of 100% (rounded off to nearest whole number) which means its portfolio consists almost entirely of issuers whose securities have witnessed a trade in the market at least once in the past three months. In the case of IDFC Credit Risk Fund, 87% of the fund’s underlying issuers have had their respective securities traded at least once in the past three months. As seen in the chart above, the LiquidityScore of IDFC Credit Risk Fund is superior to peer funds in the credit category. Moreover, LiquidityScore tends to wane as the portfolio skew increases towards lower rated credit papers (“High Yield” funds have the lowest LiquidityScore).
 

In this context, it is important to note that credit spreads have, in fact, benefitted from this shallow liquidity amidst the sharp sell-off in AAA bonds witnessed over the last few months (highlighted in our note, Value Investing - The AAA Way Part 1 & 2). Consequently, higher yielding funds with low underlying liquidity have outperformed the broader market, benefitting from this anomaly. However, this could be transient in case flows towards credit oriented funds were to continue to trend lower or even turn negative for a sustained period of time. In such a scenario, lower rated securities having weaker liquidity will possibly see a sharper re-pricing (widening of credit spreads), thereby reversing this recent outperformance.
 
Further, we reiterate our view 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.

 

Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
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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

AAA Corporate Bond sell-off

 

Corporate bond yields have witnessed a substantial rise in the past few months, as can be seen in the chart below. The reasons for this have been articulated through various notes in the past.

 

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What happened in the non-AAA corporate bond space?
 

Having witnessed such a rise in AAA corporate bond yields, it is worthwhile to examine whether the same has percolated to the lower rated corporate bonds as well. The corresponding move in lower rated corporate bonds attains more importance in light of limited liquidity for such bonds thereby resulting in sub-optimal price discovery (as highlighted in our note ‘Liquidity in Credit Markets, July 2017).

 

The efficiency (or lack of it!) in pricing of lower rated corporate bonds can be gauged by looking at Yield-to-Maturity (YTM) differential of various credit funds vis-à-vis the IDFC Corporate Bond Fund (Since inception, the Scheme has invested entire corpus in AAA rated instruments).

 
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As can be seen from the charts above, there has been a significant compression in credit spreads. Importantly, in the past few months, this spread compression is attributable primarily to the sell-off in AAA segment rather than any meaningful improvement in the underlying credit cycle. Also, credit spreads in the ‘mid yield’ segment have not narrowed as sharply as the ‘high yielding’ segments due to relatively better liquidity and price discovery.

 

Takeaway for fixed-income investors

 

The sharp rise in AAA corporate bond yields and the credit spread compression have important implications for fixed income investing decisions. In a way, the ‘AA & below’ segment yields not having kept pace with the AAA yields also implies that investors are not being sufficiently compensated for taking the same amount of credit risk as they were in the past. Therefore, from a risk-return standpoint there is a case for incremental fixed-income allocation towards AAA bond funds given the compressed credit spreads and value buying opportunity in AAA bonds.

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Product Label:

 

IDFC Corporate Bond Fund

 

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

Awaiting MSP For Bonds

By: Punam Sharma

The much-awaited announcement on summer crop Minimum Support Prices (MSP) came through this week. The prices are in line with the budget announcement of 1.5 times cost. Most commentary post the release is understandably hazy since, while the numbers on paper look alarming in terms of impact on CPI, it is yet unclear how effective and comprehensive the implementation is likely to be. Direct CPI impact is largely expected in the 30 – 90 bps band, with the impact rising towards the higher end of this range the more efficient the procurement becomes. The other important aspect is the fiscal cost of this implementation. Government ministers seem to have pegged the fiscal cost at around INR 15,000 crores. It has been confirmed that the costs are already built into the expanded food subsidy bill in the budget (an increase of INR 29,000 crores over last year is budgeted in overall food subsidy bill) and that fiscal deficit target will not be breached. Others in the government have also expressed confidence with respect to CPI post the release of MSP.

 

There are two broad ways that the implementation can work:
1. There can be direct procurement at an expanded scale through central / state / mandated private sector agencies. This involves an actual purchase of produce from the farmer. This will set a higher effective floor to prices thereby benefitting the farmer and will impact prices (and hence CPI) more than it does the fiscal.
 
2. The government can choose to compensate farmers for the difference between MSP and market prices (if market prices are lower), without actually expanding procurement. The compensation may be capped at a certain amount and may be shared between centre and states via a pre-determined formula. This will impact the fiscal much more and most of the CPI impact will largely only feed in from the second round effect of better incomes.
 
However, it is to be noted that if both price and fiscal effects are subdued then one can conclude that the whole exercise hasn’t had the desired welfare effect; which isn’t the intent at all.
 
Also, as seen in the chart below, buffer stocks in paddy are very large. This is alongside a material rise in production as well. Further aggressive procurement may only swell these stocks more and may be quite counterproductive in the medium term.

 

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The scenario on pulses has also changed dramatically over the past couple of years – from shortage to over production, as seen in the charts. The point here is that in some cases, establishing a sustainable higher market price via widespread procurement may not be a very practical idea. Reasons of import price distortion and adverse terms of trade may be other considerations as well. These lend support to the view that the actual impact on CPI may be much more muted than the on-paper calculations suggest.

 
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Source: CEIC. Note: FY18 numbers are based on the 3rd advance estimates of food grain production released by the Ministry of Agriculture
 
The Big Picture
 
It is important not to lose sight of the big picture view in this micro discussion on MSP. As the chart below shows, food prices have been declining almost secularly over the past few years with the cause-effect circularity flowing among lower MSPs, lower real rural wages and lower food prices.
 
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Source: CEIC, PIB. Note: 1) Real rural wage is nominal rural wage deflated by CPI-rural. 2) There is a break in data from November 2013 to October 2014.

 

This trend is likely now starting to change. While the current quantum of MSP hikes may not get repeated now that the cost plus formula has been implemented, it is likely that policy focus remains conclusively on the farm situation for the foreseeable future. All of this argues for a higher steady state food CPI and hence a higher steady state overall CPI.  The non-food basket could compensate in the time ahead, largely in two ways: 1> further rationalization in GST rates once revenue buoyancy stabilizes 2> the non-food basket itself changing at some point in the future to incorporate newer consumption patterns. However, this compensation may still be some time away.
 

It is also noteworthy from the chart above, that this new regime on food inflation has almost exactly coincided with the regime of CPI targeting framework of the RBI. In that sense, the framework ‘has had it easy’ thus far. If food inflation were to sustainably find a higher floor, it is quite likely that RBI / MPC focus on 4% CPI target will get challenged. This is because it may require a disproportionately large rate increases (and corresponding loss of output) to dis-inflate the residual part of CPI basket.
 

Rather, we think that the RBI / MPC will eventually adopt a pragmatic approach and focus on their controllable: the real policy rate buffer over average forecasted CPI. This in turn will be a function of local growth prospects and financial stability concerns. In our current view, local growth will likely begin slowing from its current pace over the second half of this financial year. This leads us to believe that this will be a shallow rate cycle. At this juncture, we are looking for another 50 bps of hikes by March of 2019. The risk to the view may come from financial stability concerns. Should global volatility escalate then the RBI / MPC will likely settle for a larger real rate buffer.

 

Conclusion

The CPI impact of the new MSP announcements remains ambiguous for now. A lot depends upon effective procurement as well as the starting availability dynamics for the crops. However, it is very likely that average CPI for the year gets pushed comfortably beyond 5%. This is particularly unhelpful given the already adverse macro dynamics currently underway. The RBI / MPC will be decidedly worried with these dynamics. For that reason, it is prudent to believe that the residual rate hikes in this cycle will come front loaded. We would think August policy is very much in play for the next one, to be followed by one more before the end of the fiscal year.
 

Given these CPI dynamics, one can potentially argue for a steeper rate hike cycle. However, we think that the RBI / MPC is currently too sanguine on growth dynamics. In our view, there is strong likelihood of a sequential slowdown in growth over October – March. This is especially true in light of the significant recent tightening in local financial conditions. Assuming no further escalation in global financial volatility, these dynamics should keep this rate hike cycle shallow.
 

Bond yields at the front end (up to 4 – 5 years) seem to be more than fully pricing in a shallow cycle.  This has been our preferred overweight segment for some time. The larger issue has been demand – supply. While selling by foreign investors over the past few months has further made demand versus supply adverse, there are potential green-shoots on the horizon:
 
1. Public sector (PSU) banks seem to be nibbling in the market again for the past few weeks. This is evident both in primary auction clearance as well as secondary market activity to some extent.
 
2. Around INR 20,000 crore odd of government bonds in the 2020 and 2021 segment have been taken out from trader books by ALMs, PSU banks and RBI open market operations (OMO). This has reduced float in the segment thereby lending some element of incremental stability.

 

Apart from these, should foreign investor selling ease on relative stabilization of the global environment it would be positive. However, the biggest potential positive is the resumption of OMOs from RBI. While they are likely to be sporadic over April – September, we expect them to become fairly regular over the second half of the financial year. This will constitute the biggest support to bond prices.

 

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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