AMC Speak 6th November 2014
Fixed income meets all 4 criteria of a classic value story
Sankaran Naren, CIO, ICICI Prudential MF


Naren's team produced a cogent note on 16-Oct-2014 titled "Life @ 8.5%" which articulated a strong case for investing in long duration fixed income funds. Markets in the last two weeks have already started moving in the direction this note speaks of. We asked Naren a few follow up questions based on this note - ranging from really how overweight one should go on fixed income now to a couple of global factors that could influence our fixed income markets, going forward. Naren makes a categorical assertion : fixed income meets all the 4 criteria of a classic value story and therefore is a very attractive asset class right now. Read on to understand these 4 factors and why Naren believes you should be actively getting clients into long duration funds now.

Click Here to download the note "Life @ 8.5%" of 16-Oct-2014

WF : For advisors who practice tactical asset allocation, would you suggest they go underweight in equity right now and overweight in long duration funds? To get a clearer perspective, if the strategic asset allocation towards equity for an investor is pegged in the range of say 40-60%, should we be now closer to the 40% levels or somewhere in between around the 50% levels? Likewise, to what extent should one go tactically overweight on long bonds now?

Naren : Investors should adhere to asset allocation model depending on their risk appetite. The asset allocation model instils discipline in investing, helps avoid the tendency to redeem at market bottoms and invest at market tops. When equity markets are richly valued, investors could allocate towards equity strategies which are defensive (have cash allocations), so that if the markets offer opportunity over the next few months or one year, these strategies will have enough cash to buy equities.

It may be a prudent strategy, thus, to invest in funds of the balanced or dynamic category. These funds seek to book profits when markets have risen and buy more equity when markets are cheap. ICICI Prudential Balanced Advantage Fund& ICICI Prudential Dynamic Plan are interesting offerings in this space.

Also, given that India's CAD has corrected and inflation numbers have come down along with attractive valuations and fear in the market, long-duration fixed income is a suitable asset class to invest in at this point of time. We believe that investing in fixed income duration in India is currently a value investment strategy. An asset class offers value when there is fear, lack of flows, low past returns and low valuations in the market and at this point fixed income meets all the four criteria.

WF : Can you provide your perspective on two external factors that can potentially influence our debt and equity markets?

  1. End of QE in US followed by rate hikes there, potentially diverting bond flows away from emerging markets towards US

  2. Naren : The impact of bringing down interest rates to zero has been witnessed by economies across the world, but the economics has not been tested for an increase in interest rates from zero back to 2-3 per cent. This is the first time it is happening in the world. Consequently we have to understand how the laws of economics and markets behave in these situations.

    From a global standpoint, over the course of next 6-9 months the global market has to absorb the monetary policy stance in the West and the stoppage of quantitative easing which could present near-term headwinds. However our long term view on India being one of the biggest structural opportunities in the world remains intact.

    In 2007-2011, as the first phase of quantitative easing began (QE1) in the United States (US), the 10-year US yields fell sharply from 4.62 per cent in 2007 to 2.76 per cent in 2011, however, the 10-year yields in India rose from 7.95 per cent to 8.33 per cent. Past trends indicate, that the correlation between the 10-Yr US yields and 10-Yr India yields are low.

    With the 10-Yr yields in India moving in opposite direction to the WPI & CPI Inflation, the fixed income market has become extremely attractive. (Ref Table)


  3. Rally in the US dollar which many experts believe has started a long term bull run, and its potential to draw flows away from emerging markets and into US treasuries

  4. Naren : The trend in the current account deficit has shown considerable improvement since 2013, with FY2014 CAD narrowing to 1.7% of GDP from 4.8% of GDP in the previous year. With CAD taking a benign trend, India is unlikely to be impacted.

Click Here to download the note "Life @ 8.5%" of 16-Oct-2014

WF : In your note, you highlight the improving current account balance as one of the 5 factors that underpin your bullishness in long bonds. To what extent is this improvement structural? Is the improvement largely on account of a fall in oil prices? If so, can we hope for oil prices to remain weak for an extended period of time?

Naren : RBI has been persistently taking steps to structurally improve the CAD situation and thus, a fall in merchandise trade deficit along with marginal rise in net exports of services amongst other factors have led to lowering of CAD. The recent fall in oil prices is likely to further bring down the import bill and lend stability to the INR as CAD narrows. Commodity prices are likely to stay down at multi year lows as weak China demand leads to global over supply.

WF : One of the 5 points in your note talks about an increase in savings rate, led by improvement in real interest rates on the back of dropping inflation. To what extent can this be negatively impacted by falling interest rates - i.e., if interest rates fall in the next 2-3 years, will real interest rates continue to be attractive for savers or is money then likely to find its way towards equity markets due to low absolute returns from fixed income instruments?

Naren : One of the prerequisite of entering into a high growth trajectory for an economy is to have High Savings Rate. For most countries, the peak of their GDP growth coincided with higher savings rate. Growth in any economy is savings multiplied by incremental capital output ratio (ICOR).

So if we increase the savings rate and assume ICOR will remain the same, it can easily translate to GDP growth over next couple of years. There lies a negative correlation between savings rate and interest rates; falling interest rates could prompt investors to move money towards the equity market. We recommend investors to participate in the growth of equities over the next 3-5 years, through the mutual fund route.

WF : Why is sentiment towards long bonds negative right now? Why are we seeing outflows from debt funds which are traditionally the preferred choice of well informed institutional and corporate investors? Is it caused by a view on markets or a reaction to recent tax changes?

Naren : Inflows into duration funds have been negative in the recent past and the medium-term performance (over the past two years) of debt funds as a category has been below average. Given the way equity markets have been performing lately, investors seem to be ignoring this well-placed asset class.This has resulted from the concerns on overhang of gilt supply, possible fiscal slippage in India and an impending rate hike in the US. However, macroeconomic improvement and fiscal prudence could bring down interest rates over the next 2 to 3 years.

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