Dhawal Dalal: Focus on Higher Maturity Fixed Income Funds

Image: Danish Siddiqui / Reuters

Steps taken by the RBI are likely to have a positive effect on inflation in 2014

The trajectory of headline inflation in India has been relatively volatile lately.  Headline WPI touched a peak of 11.15 percent in July 2008 due to a spurt in crude oil prices, and fell sharply to almost zero in June 2009 due to the global financial crisis. From there, the WPI rose back to around 10.88 percent in April 2010 amid a sharp increase in food and fuel inflation.

In 2014, we do expect one more rate hike, or perhaps two, depending on how headline inflation behaves and then a prolonged pause is expected until the previous rate hikes have had a meaningful impact in bringing down headline inflation on a sustained basis.

In order to determine if bond yields could rise further in 2014, we need to find out the future trajectory of headline inflation, as well as what will likely happen to real yields in G7 countries. It is important to note that if real yields (nominal yields net of headline inflation) trend significantly higher from their current levels in the developed countries (not our base case for 2014), then it may exert an upward pressure on local bond yields as market participants may demand higher yields.

In order to understand the dynamics of headline inflation in 2014, we will be keenly watching the revival of the global economic cycle as well as India’s parliamentary elections due in May 2014 for further cues on inflationary pressures. If the global growth cycle accelerates from its current level, then it may result in increased demand for key commodities and crude oil. Rising prices of key commodities will be broadly reflected in the higher output prices as the manufacturers—some of them are already experiencing pressure on their margins—may be forced to revise their prices up.

Similarly, a decisive outcome in the upcoming elections may result in significant improvement in sentiment, which may increase consumer demand and may cause temporary supply/demand mismatch resulting in general price increases.

We are also looking for signals that will point to a possible revival in investment spending in India. The impact of interest rates on investments is a function of the availability of liquidity in the market. Generally, in the initial phase of revival of the economic cycle, there is ample liquidity in the banking system, which may keep interest rates from rising. As the investment cycle gathers momentum and the pool of available liquidity begins to dry up, then it may push the cost of credit higher, commensurate with the demand for credit.

The government’s policy to reduce fuel subsidies may also have a significant bearing on inflation going forward. If the government decides to go for a one-off upward revision in diesel price, then the headline inflation will increase temporarily, but will gradually start trending lower as demand may start getting adjusted to higher fuel prices. The RBI may also step in to contain inflationary pressures. However, a commensurate increase in manufacturing productivity may help offset inflationary pressures in some cases.

It is worth noting that the benchmark 10-year yield has not traded above the 9 percent level for more than 60 days in the last 2,500 trading days. From that perspective, we believe the government bond yields appear attractive. Having said that, we believe government bond yields are not going to decline sharply in the near-term. Subdued sentiment, lower appetite for EM bonds and developments in the global markets may continue to support high yields. At the same time, we believe the steps taken by the RBI will likely have a positive effect on inflation, which we believe, will trend lower in 2014.
 
We believe that government bond yields are closer to their peak.

We are asking investors to start investing in fixed income funds with higher average maturity. But they must invest for at least a six- to nine-month time period. We are now asking investors to consider investing in higher average maturity funds because we believe the worst may be behind us. If you have Rs 100 to invest for at least a six- to nine-month investment horizon, then we suggest you consider investing Rs 40 to Rs 45 now, and add more as yields trend higher (for various reasons, including one more rate hike is perhaps still due). However, stay with quality and with funds where you can redeem easily.
 
Although we are generally bullish on the bond market at current levels, the market also has a tendency to surprise with ‘unknown-unknown’ risks. Known risks are inflation, EM currency weakness and EM debt outflows. It is the ‘unknown-unknown’ risk that is tough to price in and the way you do that is by staying invested in liquid assets. If and when such risks should come up, one should be able to sell assets quickly and seek to mitigate the risk.

In general, investors are better off buying short-maturity bonds when the interest rate cycle has bottomed out or is looking to trend up. Similarly, investors are likely to benefit by buying long-maturity bonds when the interest rate cycle is closer to its peak and is looking to trend down. In the current environment, we believe that the interest rate cycle is closer to its peak. Therefore, based on that, we advise investors to buy long-term bonds. In case of persistently high inflation, investors should purchase inflation-indexed bonds (CPI may be a preferred inflation gauge) that will seek to protect the erosion of their purchasing power and one that offers attractive real yield.

We would ask investors to also consider investing in dynamic bond funds. These funds have the flexibility to invest in various fixed income securities and across tenors. We believe these funds are ideal because they have the ability to extend their average maturity during bullish phases as well as mitigate risks by sharply reducing their average maturity during periods of heightened volatility.

(As told to Shravan Bhat and Pravin Palande)