By Rajeev Radhakrishnan
Interest rate risk as a factor in fixed income investments have been fairly appreciated, especially post the overnight tightening in rates by the RBI during the “taper tantrum” episode in mid 2013. Credit as a key theme in fixed income portfolios have taken center stage since then. At the same time, credit risks arising out of factors such as rating migration, credit spread realignment as well as default probability have been relatively underappreciated till now. Recent market developments in the Indian fixed income space arising out of the default by an erstwhile AAA rated entity and the subsequent market actions driven by liquidity freeze for certain non banking entities have brought credit risks at the forefront of considerations prior to investing in fixed income funds. The appreciation / awareness on credit risk is a desirable development in the evolution of fixed income investments, especially through debt focused mutual funds. Recent regulatory actions on product classification have also aided investors in understanding the extent of risks and the mandates of various funds. These guidelines broadly define duration limits in most funds, except for the credit risk category (min 65% in AA and below) and corporate bond category (min 80% in AA + and above) where the credit related exposure is defined. Investors in fixed income funds should actively assess the credit risks in fund categories wherein the categorization is only on the duration range, which only addresses the interest rate risks. These categories include the liquid, ultra, low duration, short term, medium and long term funds and also funds categorized as floating rate.
As regards, the monetary policy rate expectation, the current assessment based on expected inflation and growth trajectory calls for a relatively shallow rate hiking cycle. With policy rates having been increased preemptively by a cumulative 50 bps so far and the tightness in systemic liquidity driven both by currency withdrawals and FX intervention, the market yields have moved up materially over the last year. Softness in food inflation have enabled CPI numbers to print below estimates, even as core inflation remains sticky at close to 6%. While a sticky core inflation warrants caution, subdued inflation in food items and recent softness in crude oil prices provide comfort. Even as we expect some mean reversion in food prices, the headline numbers are unlikely to move up beyond the tolerance band with broad expectations around a longer term range not exceeding 5%. The continued focus on moderating long term expectations at 4% by the RBI is encouraging from an investor perspective. The potential for consumption demand to soften over the coming months driven by some of the recent financial market turbulence should also be kept in mind while assessing future inflation outcomes. Policy rate outcomes in other markets are likely to diverge with soft growth patches emerging in both China and the Euro zone, while the US continues to gain from the late cycle fiscal stimulus. At the same time the coming year would witness a more synchronized quantitative tightening as both the US and Euro zone exits the QE regime.
Indian fixed income market
Market action in recent weeks have been driven by the movements in the currency markets which have in turn been impacted by the direction in crude prices and vice versa. In the near term, such cross linkages would continue to impact yields, which can also be impacted by domestic events surrounding election outcomes as well as developments surrounding frictions between the government and RBI on various policy issues. While event risks surrounding these factors as well as external geo-political developments impacting crude prices are hard to estimate, the domestic factors such as government fiscal challenges, tighter liquidity, credit demand in the system and demand supply dynamics point to yields, especially at the longer end remaining under pressure for a while. Material concerns remain on the revenue side assumptions of the fiscal numbers, even as recently announced MSP measures such as price deficiency support payment etc and national health (Ayushmann Bharat) mission are rolled out. These programs may be under budgeted especially on long term sustainability in the absence of revenue side tax buoyancy. As regards the demand side, RBI OMO purchases have enabled yields to stay in a range even as recent pick up in credit – deposit numbers could lead to some drawdown in excess SLR held by banks. Some of these challenges are expected to play out over the next few months, especially over the remainder of this fiscal year. This may provide reasonably attractive opportunity to look at the investment in duration products such as Magnum Gilt Long term or SBI dynamic bond fund. A staggered allocation over the coming months also with an investment horizon that can stay through an entire interest cycle is suggested at the minimum for optimal allocation. It may be kept in mind that currently the starting point is after rates having moved up more than 170 bps since touching the lows of around 6.10% in early 2017 and policy rates having been hiked 50bps. The expectation of a shallow rate cycle as mentioned above supports such an allocation.
For risk averse investors, the current elevated yields at the shorter end and any expected easing of rates over the entire interest rate cycle can be captured through SBI short term fund. The fund maintains a lower duration band of between 1 to 3 years and a portfolio biased towards higher credit quality papers. At the same time, for investors with lower interest risk tolerance, FMP remains very attractive currently. Short term cash deployment can be used through either the overnight funds that invested only in repo which is collateralised by government securities or through SBI liquid fund that provides a reasonable carry over the overnight funds, but with exposure to commercial papers.
The author is currently the Head of Fixed Income, SBI Mutual Fund.