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WF: How have bond markets responded to RBI's recent 50 bps rate cut and how do you see markets moving in the coming weeks?
Prashant: Immediately after the monetary policy announcement, yields on 10 yr G-Secs fell by 20 bps from 7.73 to 7.53 levels. The entire curve shifted 15-20 bps, corporate bonds too saw yields dropping by 15-20 bps.
Going ahead, we see potential for a further fall in yields, largely influenced by favourable demand-supply situation. RBI has provided a calibrated roadmap for enhancement of FPI purchases, which will augment demand, and this coincides with the lean period in terms of supply of paper.
We see disinflation continuing to be a key theme, with soft global commodity prices aiding this process significantly. This too augurs well for further decline in interest rates.
WF: Are we now in pause mode for the rest of the fiscal, after this "front-ended" rate cut?
Prashant: This "front-ending" is essentially RBI's attempt to encourage transmission of rate cuts into the market by banks. Transmission is essential to aid GDP growth.
But, this does not mean that RBI is done with rate cuts. 3 months ago, we stated that we see 50-75 bps rate cuts this fiscal. We've seen 50 bps now, and we think we will see another 25 bps later in this fiscal year.
Growth worries are not going away in a hurry, and that will keep interest rates in a declining mode. While we are seeing reforms and Government policy action, it is taking time to create the desired impact on growth momentum.
CPI may spike marginally higher after the favourable base effect wears off, but it is still likely to be within RBI's comfort zone. Like I mentioned earlier, continuing softness in global commodities will help keep inflation within control.
RBI is also seeing progress in fiscal discipline by the Government - which will boost its confidence in continuing with an accommodative monetary policy to aid GDP growth.
WF: Where do you see 10 yr G-sec yields by end of this fiscal and what will be the key drivers going forward?
Prashant: We believe that the 10 yr G-Sec yields which are in the 7.50% levels now, can go down to around 7% by March 2016. We also believe overnight yields which are in the 6.75% levels now, can go down to 6.50% or below by March 2016.
WF: Should our bond markets be concerned about the imminent commencement of the US rate hike cycle?
Prashant: Beyond any possible initial kneejerk reaction, no I don't think there is a reason for us to worry. There are two reasons: one is that FPI exposure to our bond market is as yet very limited, and therefore unlikely to create a material impact. Second, we are moving towards a lower inflation trajectory and US is forecasting a move towards a higher inflation trajectory, albeit from a very low base. This means that over time, inflation differential will actually reduce and not increase between the two countries. Usually, widening gap induces flows - this is not the case between US and India.
WF: Where are the best opportunities today in the fixed income market?
Prashant: Long duration funds continue to be attractive, as we see 10 yr G-sec yields continue to soften for the rest of this fiscal, as already mentioned.
There is another segment of the market which I would like to draw advisor and distributor attention to. Short term funds in my view are likely to benefit from bull steepening of the yield curve. The 1-5 year segment looks particularly attractive. Banks will transmit lower rates into the market, FPI demand will drive up liquidity in the system. Both these factors we believe will put downward pressure on overnight and short term yields. Short term funds that focus on the 1-5 year segment should benefit from this move.
WF: A recent credit event has put a spotlight on the industry's credit opportunities funds. There continue to be concerns on credit quality in fund portfolios and on illiquidity of underlying assets in products that promise high liquidity. How do you see the industry's position on this product segment? How real are the risks and how prepared is the industry?
Prashant: You are right - liquidity concerns are worrying the market. The corporate bond fund segment had an assumption that underpinned its growth - which is that inflows will continue and will be higher than outflows. So long as this was happening, the illiquidity of underlying instruments was not a major concern. The moment this stops or looks like reversing, liquidity risk becomes high.
Now, we must understand that not all corporate bonds are illiquid. The higher rated bonds are liquid, and can be transacted, at a price. It is typically the AA- and below papers that are illiquid. Funds that have sizeable allocations to higher rated bonds should be able to handle liquidity issues far better than those that have a very high proportion of lower rated papers.
The only way to manage liquidity risk is diversification across three parameters:
Issuers - to reduce concentration risk of exposure to one company/group Ratings - judicious mix of ratings, which also provides liquidity in the higher rated papers Maturities - have a laddered maturity profile to help deal with cash flow problems, if any
Fund houses that have taken these precautions are well equipped to deal with the current set of worries.
WF: What is the extent of AA and lower papers in your credit funds and what steps are you taking to avoid credit accidents?
Prashant: 61% of our corporate bond portfolios are in AAA, AA+ and AA - which are relatively more liquid. The balance is in AA- and below, which are relatively illiquid. We are comfortably placed to deal with liquidity risk.
You can avoid credit accidents if you put in place a robust independent credit appraisal mechanism. I have to stress on the word independent here - it is only when the credit evaluation team is independent of the fund manager, can they provide a truly independent input into the credit selection process.
Second, you need tight risk control mechanisms - not only at the credit selection process level, but down to deal execution as well. A deal should not go through if it is in any way out of line from the laid down process. This control should be at the deal execution level, not just at a post facto monitoring level.
At Reliance MF, these processes are truly institutionalised, which gives a robust framework that gives us the confidence that complete due diligence will be conducted before any corporate bond is bought.
WF: What would you advise distributors to communicate to investors who are concerned about risks in corporate bond funds?
Prashant: Investors are concerned, and distributors do have a challenge in assuaging their fears. Distributors should ask investors to take comfort from the fact that the credit environment is improving. The ratio of ratings upgrades to downgrades is continuously improving. Interest rates are coming down, which is easing pressure on some of the stretched balance sheets. Liquidity in the system is improving, which also gives relief to businesses that are experiencing cash flow problems.
In fact, if you really look at corporate bond funds now, the opportunity is looking better and not worse, as corporate bond spreads are widening. This is actually an opportunity to invest in corporate bond funds, rather than exit from them.
That apart, one thing that I would encourage distributors to focus on a lot more is to go beyond just the gross yield of portfolios when deciding allocations. Please analyse portfolios properly before advising clients on corporate bond funds.
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