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WF: How does the recently announced bank recap plan impact debt markets?
Dwijendra: The Government estimates the impact on fiscal deficit to be limited to Rs. 8000-9000 crores, which is basically the interest component of these bonds. So the direct impact is limited. That said, we need more clarity on the features of these bonds. If they are tradable, there can be supply side issues in the market. If we go by precedent, they should remain non-tradable - which won't impact bond markets. These bonds will however increase our overall debt to GDP ratio - but my belief is that the market has already discounted this.
WF: Should we brace ourselves for a rate hike now or can we expect the gradual rate cut cycle to continue?
Dwijendra: There are a few concerns on the horizon that we must be watchful of - which can impact the direction of interest rates. Crude oil prices are now 40% higher than what we paid last year - this will impact our inflation numbers, it will impact a cross-section of industries that consume oil, though pump-level price increase incrementally has been restricted to 10-11%. Pressure from higher oil bill on our current account can impact the rupee, and the rupee does have a bearing on inflation levels. Studies have shown that a 1% depreciation in the rupee can cause a 20 bps rise in headline inflation - and vice versa for an appreciating rupee.
Then we have liquidity withdrawal by US and ECB. Liquidity has been a key driving force for global asset prices for several years and when that delta is withdrawn, albeit gradually, it can have an impact on flows. We have to bear in mind that in CY17, India received close to US$ 30 Bn in FII inflows - 23 Bn in debt and the rest in equity market. Drying up of those flows or some amount of reversal in flows can materially impact the rupee's level, with implications on our bond markets.
We need to be watchful about these global factors - there is no immediate cause for worry - but we certainly need to track these events closely.
Coming to the issue of whether to expect a rate hike, I believe markets have already discounted a 50 bps rate hike. The median spread between the repo rate and the 10 yr benchmark, which historically is around 50-55 bps, has already increased to 100 bps. Long bond yields have already reacted.
The problem with rate hikes honestly is that in terms of market expectations, markets rarely expect only one rate hike - they start expecting a series of rate hikes. RBI has to manage this situation delicately as it grapples between finding the right equilibrium between fighting inflation and promoting growth. If you look at the comments from the members of the Monetary Policy Committee, which is now available for all to review, we find among the 6 members, 1 is neutral, 1 is dovish and 4 are hawkish in their stance. So that again gives us a useful insight into how RBI's policy making body is thinking on rates.
WF: In what ways have you aligned your duration strategies in response to the recent market developments?
Dwijendra: All our duration funds have clearly defined duration buckets within which they operate - we do not believe in allowing fund managers infinite risk levels. Currently, they are all at or close to the lower end of their respective duration bands.
WF: Does it make sense now to invest in income funds and dynamic bond funds?
Dwijendra: I have said this on Wealth Forum before and I will reiterate again - long term income funds ought to be considered as retiral income products which you hold for long term horizon. We are doing a disservice to this segment by only looking at it as a tactical allocation during rate cut phases. India is gradually gravitating towards a low inflation environment. 8% used to be the norm, now 4% is what RBI is targeting. As we progress towards a sustained low inflation environment, investors will benefit from rolling down the curve on long bonds, if they take a 10 year + horizon, which is the typical norm for retiral products. Today, the real rate of return is 2-2.5%, internationally it is closer to 1%. As we move towards that trajectory, there are capital gains to be made from income funds apart from the accrual from long term bonds. The key is to ignore short term fluctuations and take a genuinely long term view.
For those with a shorter term outlook, the next 2 years could be volatile in long bonds and therefore opportunities for tactical gains may be limited. But, as I reiterate, there is very good scope - which continues to be under-exploited in positioning income funds with SWPs as tax efficient retiral income products with a 10 year horizon.
WF: Should investors in credit funds assume only accrual income for the next couple of years and not consider any likely gains from capital appreciation?
Dwijendra: That would be a fair assumption. But here again, it is important to look out for credit funds with modest to low duration. A credit fund with a 4-5 year duration can hurt you in the current environment if you have short term investment horizon.
WF: How are corporate spreads now and what opportunities do you see in these?
Dwijendra: The 3 year segment is clearly overpriced, in our view. In the 10 year bucket, corporate spreads are 60-70 bps, they are in the 30-35 bps range in the 5 yr bucket but come down to only 15-20 bps in the 3 yr bucket. Domestic taxation (3 yr holding for LTCG) as well FII restrictions on participating in longer term than 3 yr bucket mean too much demand in the 3 yr segment, causing spreads to come down to unattractive levels.
WF: Where do you see the most attractive opportunities in the debt market now?
Dwijendra: I believe state development loans - issued by state governments - represent good value now. While the 10 yr G-Sec trades at 6.90 - 7.00% range, state loans are trading at 7.60 - 7.70% - a spread of 70-75 bps, which is perhaps too high considering the actual risk in state government loans. We don't believe state governments - at least many of them - will default. There are attractive opportunities in this segment. If inflation remains at 5%, the real rate of return on state development loans is around 260 - 270 bps - which is quite attractive.
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