People who have read the RBI policy fine print says Governor Das has actually delivered some kind of a Quantitative Easing package, aimed at taming the yields. Does that in some way change the equation for debt funds? If so, how? How should debt fund investors respond to this?
First, from an emerging markets central bank perspective, the route to come out of a crisis without considerably disturbing the financial stability bears the following waterfall mechanism (in the same order): Currency > Liquidity > Monetary rates > Market yields > Fiscal Stimulus. Unless the top layers are stabilised, any attempt to push through the lower layers would not only disturb the financial stability, but also lead to underutilisation of finite ammunition, thereby risking sustenance of growth revival.
If we look back since the onset of the crisis, RBI has been spot on in trying to stabilise the respective layers in the waterfall mechanism mentioned above. First round of measures started with currency swaps and sustained accretion of foreign exchange reserves. This was followed by cut in cash reserve ratio (CRR) and TLTRO, which allowed RBI to sustain super-surplus liquidity in the system. The cut in monetary rates (repo rate) in the backdrop of liquidity surplus aided the front end of yields to soften through the first half of the financial year. With a large part of conventional tools used up to anchor shorter-end rates; RBI at its latest MPC meet unleashed measures to cap upside in market yields by announcing a series of tools to address the demand-supply math of bonds, and thereby, help address the extent of steepness in the yield curve. Higher sovereign yields and prospects of further hardening in sovereign yields can prove detrimental for peripheral interest rates in the economy to stay lower so as to turn the tide on growth. As the yield curve flattens; addressing both cost as well as availability of money for the broader economy, the government stands better equipped to unleash the fiscal stimulus to sustain a reversal in growth cycle.
In line with the above order, we expect the yield curve to flatten from current levels. We align the fixed income funds basis above and curate the portfolio composition to reflect the above view.
In the past few weeks, NAVs of different categories of funds (for example: PSU/banking, corporate bond funds, etc) have traded in a narrow range. These categories were ‘hot’ a couple of months back. Will low returns be the norm for a while now?
NAV for any category of fund reflects accruals as well as price movements in bonds that the fund has invested in. Bond yields have been trading in a very narrow range through the past few weeks, awaiting more clarity on various issues ranging from government borrowing to MPC stance on recent rise in inflation to overall response of policymakers and regulators to revive the growth cycle. As the recent announcements addressed a few of these issues, bonds yields have moved out of the narrow range denoting increase in capital gains as yields moved further lower.
Drivers for fixed income are two pronged – accruals and capital gains. When we get both, it is indeed a bonus! Accrual profiles of funds have indeed dipped and the prospects remain in extent of flattening of the yield curve.
Looks like we are going to be in a low interest regime for a long time to come. But inflation remains high for a while. How can a debt market investor generate inflation-beating returns?
Through a low interest rate regime, central bank actions globally tend to push investors to add one layer of risk to derive returns. From the fixed income perspective, the next layer of risk is identified with duration or credit. That said, for a long-term investor (beyond one-year horizon), it is indeed imperative to mitigate/hedge the risks of rate reversals. Where there’s a problem, there lies a solution too!
To meet expectation on fixed income investments, we prescribe to tick the four boxes – liquidity, predictability, returns and lower volatility. Liquidity doesn’t mean need for money, but it implies the ability of investments to reset when rate cycles move from one phase to another. Apportioning investments into short-end roll-down funds and open-ended funds bearing the ability to maintain higher duration can help tick these four boxes across the phases of rate cycle.
In today’s context, when the yield curve is very steep, short-end rolldown will benefit to earn accruals and stem volatility as the open-ended funds (bearing higher duration) seek to earn returns with the flattening of the yield curve. Hence, without diluting the credit or duration profiles of investments, one can strive to meet expectations on fixed income across phases of the interest rate cycle.
For some time now, the mutual fund industry has been witnessing outflows, and September saw strong redemption pressure on debt funds as well. How do you analyse this situation? What is the reason behind this outflow and which categories of funds are seeing this pressure?
The trends in fixed income funds have been positive. Through the past few months certain categories of funds (credit risk) have made way for other categories like banking & PSU, corporate bond funds, etc. Importantly, the trends in fixed income have been of inflows, and not outflows.
Recently Axis Bank’s CEO people planning for retirement should not bank on FDs as the fear of high interest rates are over. So, for people who are in their 50s and planning for retirement, is it the right to be in debt funds?
Interest rate cycles are identified with high interest rate regime and low interest rate regime. High interest rate regime is identified with accelerated economic activity, leading to problem of cost of money as well as problem of availability of money. As these dual problem accentuate, economic momentum tends to halt, marking the beginning of a low interest rate regime. On the other extreme, when the economic momentum collapses and central banks address both the problem of cost of money as well as problem of availability of money, economic momentum tends to revive marking an end to low interest rate cycle or beginning of a new growth cycle.
These cycles have played out for ages while continuing to throw up opportunities across different phases. Depending on the appetite for volatility, one can opt for apportioning between roll-down fund and open-ended funds that can help navigate the tide into retirement phase or through the retirement phase.
What is the situation in the market for AA- and below-rated bonds? Are the risk of defaults the same as was in April-May or people with a moderate risk profile bet on them? In fact we saw redemption pressure coming back after a month of hiatus in credit risk funds. When will the situation improve there?
For credits to turn good, we need positive growth momentum and lower cost of money. As of now, only one of the two are at play, and hence some element of anxiety still prevails in this segment. That said, when the yield curve flattens at lower yields, it marks the beginning of the growth cycle, in other words, the credit segment tends to outperform.
We identify the stress in credit markets basis the spreads between bank’s MCLR rates and AAA-rated corporate bonds. When the gap between these two layers of interest rates closes; credit markets witness acute stress and when the gap between these two layers opens up, lower-rated credits tend to signal lesser risks. Currently, as the gap has widened, sensitivity to lower-rated credits is far less.
Lastly, what strategies would you advise for investors for the medium term and long term in the debt fund basket?
The fear of a reversal in the rate cycle lingers, when yields are so low and investors are pushed to add the next layer of risk (duration or credit) to derive returns. To see the first ray of a rising sun, why stay awake the whole night? A rising trend in the inflation trajectory, fiscal impact sustaining growth momentum, resultant withdrawal of liquidity coupled with extent of steepness in the yield curve would set the appropriate ‘alarm’ to hint at being closer to end of rate cycle.
Cycles in the past have turned when the fiscal impulse has had a positive impact on growth, which eventually helped sustain inflation. Currently, these aspects seem a little distant, and hence, despite higher inflation prints “MPC has decided to look through the current inflation hump as transient and address the more urgent need to revive growth …”
Anecdotally, the yield curve has flattened before signalling an end to the interest rate cycle. Herein, a steep yield curve and ‘supportive’ RBI coupled with prospects of lower inflation in Q4 of FY 2021 would help flatten the yield curve (from current levels) before signalling an end to the interest rate cycle.
Amidst a steep yield curve, awaiting a reversal in rate cycle could lean towards opportunity loss, which can otherwise be captured by apportioning investments between shorter tenor roll-down funds and open-ended funds that have flexibility to bear higher duration. This will not only insulate the investment from extensive volatility (lower duration), but also help capitalise on flattening of the yield curve.