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Duration funds: 5 reasons why it ain't over yet

Team HDFC MF

2nd August 2016

In a nutshell

With Indian 10 yr G-secs now trading at multi-year lows, many fund are actively cutting duration, some are calling for a switch out from duration strategies. HDFC MF however believes there are at least 5 good reasons why the Indian bond bull market continues to have legs, and why you should persist with duration funds. Read on to understand why.

Over the course of last few years HDFC Mutual Fund has consistently highlighted through a series of notes (starting with “Last hike or no hike” in December 2013, as detailed below*) its view that interest rates in India are headed lower over the medium term. The 10-year benchmark yield is now trading below 7.2% which is down by over 160 bps from its level of 8.80% in December 2013. Despite this large fall in yields, there is further downward bias to bond yields in our opinion.

The reasons for this view are given below.

1. Fall in yields is much less than fall in inflation

The decline in 10-year benchmark G-Sec yield from its peak level of 8.80% in December 2013 is significantly less than the fall in CPI as can be seen in chart below.

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Consequently, the prevailing real yields of ~1.4% to 2.8% (~1.4% vs CPI & ~2.8% vs core CPI) available on government bonds are still quite high.

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2. High real yields in India v/s other large economies

Real yields¹ in India are one of the highest when compared to levels prevailing in other large economies as can be seen in the table below:

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3. Indian bonds real yield attractive for foreigners?

In a global environment wherein more than $ 11 trillion² worth of sovereign debt are trading at negative yields, and quantitative easing by some central banks (European Central Bank, Japan) is continuing, the availability of high positive real yields on Indian sovereign bonds makes them attractive to foreign investors. Given the significant improvement in India's twin deficits (Current account deficit & fiscal deficit) and relatively stable currency outlook, FII debt inflows are likely to be strong going forward. In fact, after a lull of two months, FII flows have turned positive in July 2016 as can be seen in table below.

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4. Inflation or Core Inflation (CPI or Core CPI)?

Given the large weight of food category (45.86%) in the overall CPI calculation, rise in food prices has been the major contributor to recent increase in CPI. Pulses inflation alone at ~27% has added about ~70 bps to headline CPI.

Since there is no linkage between food/energy prices and interest rates, it is open to debate whether Core CPI should also be considered as a benchmark for setting interest rates. Core CPI has been steadily falling since March 2014 and is around 4.5% over the last one year as can be seen in table below.

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On the back of a normal monsoon in 2016 (likely to be 104% of normal as per Indian Metrological Department) food prices are expected to moderate in latter part of the year which may lower CPI from 5.8% levels.

5. Delay in rate hike by the US Fed?

As per a recent data release, the US economy grew at a slower pace than expected at 1.2% in the second quarter of 2016 which further scaled back expectations of rate hikes by the US federal reserve. The disappointing growth data led to a rally in US Treasury prices with yields touching two-week lows and the benchmark 10-year Treasury note closing at a yield of 1.45% on 29th July 2016. It is interesting to note that the 10-year US Treasury note has rallied by 53 bps from its high of 1.98% as on March 2016.³

Conclusion and Outlook

Since 2013 HDFC Mutual Fund has consistently maintained that interest rates in India are headed lower. The 10 year benchmark G-Sec yield has come down to 7.16%4 the lowest level seen in last three years from 8.8% in December 2013. Despite this large fall in yields, there is further downside bias to bond yields in our opinion. This is so because of room for more rate cuts by RBI, high real yields (~1.4% to 2.8%), low level of core inflation, expectation of decline in headline inflation post monsoon, continuing weak IIP and strong capital inflows from debt FPIs.

In line with the above, our recommendation to investors would be to remain invested in duration funds.

The following is a summary of our duration based funds and their portfolio positioning.

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# For complete details on monthly portfolio as on July 29th 2016, visit our website, www.hdfcfund.com

DISCLAIMER: The views expressed herein as of August 1, 2016 are based on internal data, publicly available information and other sources believed to be reliable. Any calculations made are approximations, meant as guidelines only, which you must confirm before relying on them. The information contained in this document is for general purposes only. The document is given in summary form and does not purport to be complete. The document does not have regard to specific investment objectives, financial situation and the particular needs of any specific person who may receive this document. The information/ data herein alone are not sufficient and should not be used for the development or implementation of an investment strategy. The statements contained herein are based on our current views and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Past performance may or may not be sustained in future. Neither HDFC Asset Management Company Limited and HDFC Mutual Fund (the Fund) nor any person connected with them, accepts any liability arising from the use of this document. The recipient(s) before acting on any information herein should make his/her/their own investigation and seek appropriate professional advice and shall alone be fully responsible / liable for any decision taken on the basis of information contained herein.

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

¹ Real Rates refer to interest rates over and above inflation rate.

² Source: Fitch Ratings, NY-29th June 2016

³ Source: Bloomberg, HDFC AMC Research

4 (As on 29th July 2016)



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