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WF: Your recent note post demonetization alludes to potential fiscal benefits to the Government from old currency notes that don't come into the system. There is however some confusion on this score as there is a view that the liability on RBI can be called upon any time after 30th Dec too, which means that it does not get extinguished. Would your bullishness on bond markets change if it finally gets clarified that there is no fiscal benefit from the demonetization move?
Prashant: Considering the current trend in rise in bank deposits, even if we assume there will be no fiscal windfall, our major argument for fiscal benefits hinges on the increase in the Tax Revenue base. Going forward, once cash holdings are deposited into the banks to exchange new currencies, understating true income for tax purposes will be very difficult. This may potentially lead to better compliance, thereby increasing the tax base and revenues of the government going forward.
Our Bullishness on bond markets post demonetisation is basis the potential fiscal benefits, strong disinflationary impulse, near term negative impact on GDP growth & major boost to system liquidity. So all factors including fiscal benefits (albeit lower than initial estimates) will aid bond markets from medium term perspective.
WF: RBI has now rolled back its incremental CRR but has not bowed to market expectations of a rate cut. Is this a disappointment? What is your outlook on fixed income markets post the RBI monetary policy and post demonetization?
Prashant: We were surprised by RBIs decision to "Wait and Watch" for now. But we reiterate that RBI has clearly maintained the accommodative policy stance and will look for further data points to ease rates further.
By next policy (which happens to be in February 2017), the US Fed rate hike would be behind us, Annual Union Budget for FY18 would have been presented and there would be greater clarity on the impact of demonetization on inflation, growth, fiscal situation and liquidity. These developments will help provide more clarity in policy making as far as RBI is concerned. We still believe that the growth-inflation dynamics will shape in a manner that will create space for further rate cuts.
We remain constructive on Indian bonds, as demand - supply dynamics will remain favorable and domestic liquidity will remain in surplus. Also disinflationary impulses are likely to continue which would keep headline inflation fairly benign. We see limited upside risks to our FY17 average CPI inflation forecast of around 4.5% - 4.8%.
WF: Are recent developments structural in nature? Are we at the cusp of a new bull market in bonds or has the market discounted recent developments adequately?
Prashant: Structurally, we are entering a new normal for interest rates and inflation as India has joined the global peers when it started setting an inflation target and government setting fiscal targets. Post Demonetization, we expect strong disinflationary impulse in the economy. Also it will be negative for growth in the near-term, as informal sector activity, which is supported primarily through cash transactions, slows down in a knee-jerk response.
Going forward, we expect favourable growth - Inflation dynamics, continuation of Fiscal Consolidation plan, lower Current Account Deficit and ample System Liquidity to aid Indian bonds and lead to softer rates in the medium term.
WF: While we rejoice bullish times for Indian bond markets, global bond markets are witnessing a huge "Trumpflation" sell off. Are we likely to see the much feared and much anticipated bursting of the global bond bubble now? What implications might this have on our bond and equity markets and our currency?
Prashant: Global high frequency data points (GDP/PMI/employment data/inflation etc) do not indicate a sustainable economic revival for developed economies as of now. Even in US, we expect rate hikes to be very gradual and ECB taper to be slower than broad market expectations. Hence, we do not expect any major rise in global bond yields from here.
WF: How have you aligned the portfolio strategy and composition of your dynamic bond fund to evolving market conditions? What are some of the key changes you have made in the past few weeks?
Prashant: Post policy, markets have gone in a cautious mode and will await more clarity on growth and inflation impact due to demonetisation. We expect yield to move in a range over next couple of months. Thus we have realigned our Dynamic Bond Fund portfolio with this view and accordingly moderated duration by close to two years to around 6 yrs. We have shifted positions from longer end of the curve to shorter end of the curve, thus increasing allocations to the shorter end and thereby reducing the duration of the fund. As clarity emerges on the above parameters, the portfolio is liquid enough to shift from defensive to aggressive duration strategy when required.
WF: What would you say is the investment argument for dynamic bond funds now, in comparison with accrual funds and income funds?
Prashant: Despite all the volatility in the recent years, our Active Fund Management strategy in a Long Duration Fund like Reliance Dynamic Bond Fund has delivered returns across cycles. The strategy to differentiate Tactical Positions from Core Positions has paid off and our endeavour would be to follow the same philosophy going forward.
The fund does not take extreme digital (0 / 1) calls under any market scenario & tries to capture short term market moves efficiently through tactical positions to generate alpha.
We continue to advise investors to invest in dynamic bond fund from a long term investment horizon and constant debt allocation perspective and leave the timing of investment to the fund manager. We believe the fund would be more suitable for investors who are able to digest a bit of volatility compared to accrual funds. Income funds generally tend to maintain a specific duration range at all times and is not flexible like dynamic bond funds. Hence, dynamic bond funds would be a much better bet than income funds during these volatile times.
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