‘Bonds don’t like fiscal indiscipline’

Indian bond markets have seen turbulent times over the last one year with investors in long-term funds suffering sharp setbacks. In a candid interview with BusinessLine, Pankaj Sharma, CIO – Fixed Income, DSP BlackRock Mutual Fund, explains the bond market mayhem and how his portfolio strategies have shifted.

We had an in-house view that the government will not breach the fiscal discipline, as the government had taken pains in the past few years to demonstrate tight fiscal discipline.

Fiscal discipline has the ability to mask other negatives, as it can contain inflation and keep a tight lid on the current account deficit (CAD) too.

With the government choosing to pause on fiscal consolidation, inflation risks and CAD are back, and they don’t augur well for bonds. Moreover, bond yields benefited from demonetisation as slow growth aided low inflation amid ample liquidity.

With remonetisation under way, growth and inflation have witnessed a rise from their recent lows while excess liquidity in the system has reduced. Benefits for bonds arising out of demonetisation have begun to ebb as a return to growth is often accompanied by rise in inflation.

Recent worries have been compounded by elevated commodity prices, especially crude oil. Teething troubles on GST implementation led to uncertainty on tax revenues, leading to flip-flops in government borrowing numbers.

Finally, the Centre has pegged its fiscal deficit target for FY18 and FY19 at 3.5 per cent and 3.3 per cent respectively, an upward shift from the earlier glide path. Bonds don’t like fiscal indiscipline and this is reflected in the rise in yields (fall in bond prices).

The Government’s gross borrowing at ₹6.06 lakh crore is in line with market expectations. As a percentage of fiscal deficit, this is lower than last year. That said, the demand-supply equation has remained weak and markets feared that the response from the RBI to a higher deficit will definitely not be positive. The Budget on MSPs also was detrimental to bonds.

Emerging markets can withstand narrowing yield differentials with developed markets in times of strong macro stability. For India, the recent pause in fiscal consolidation and prospects of rise in inflation will be detrimental to a narrowing yield differential. Hence, rise in US yields will imply rising domestic bond yields. FPI investments follow economies that reflect stable currency, higher real rates and healthy macros. The FPI flow will be determined by how well we can demonstrate these factors.

Money market returns have been consistent, but short-term accrual funds and duration funds have provided sub-par performance. Short-term accrual funds tend to self-correct their sub-par performance within couple of quarters. On duration funds, the dent in returns is relatively high as these are high-risk, high-reward, strategies.

For managers of fixed income funds, it indeed does hurt when a product category doesn’t meet investor expectations. While the changes in government policies (fiscal stance) and timings of these changes are extremely difficult to predict, the impact of such announcement can lead to structural shift in interest rates.

New tools to hedge market risk will remain a key to improve the performance of the duration category.

We had an in-house view that the government will not breach the fiscal discipline, as it had taken pains in the past few years to demonstrate tight fiscal discipline. Accordingly, the positioning of the funds was relatively higher on duration. Increase in government borrowing in December and resultant pause in fiscal consolidation revised our views on rates. Since then, all our fixed income funds have been operating at a lower band of duration.

Our fixed income framework analyses the impact of key macro-economic variables on liquidity, rates and currency, to determine the strategies on different categories of funds.

As the macros have moved away from an improving bias, our funds have been operating at lower band of duration. Accrual, capital gains and trading are the three drivers for bond fund returns.

With the reversal in rate scenario, bond funds will have increased exposure to low duration and high-accrual assets.

Debt funds have provided a healthy alternative to traditional fixed deposits. Debt funds have grown over the last 15 years when we have seen the best and worst of interest rate cycles.

Changes in rate cycles are inevitable and different phases of interest rate cycles have customised strategies to derive returns. Liquidity, prospects of higher earnings than fixed coupons, long-term tax benefits and flexibility to alter allocation for rise and fall in yields make debt funds attractive.