With bond yields moving up sharply in recent times, passive funds on the fixed income side is the flavour of the season. Dhawal Dalal, CIO - Fixed Income, Edelweiss Asset Management, tells us where he thinks the repo rate will peak, why higher SDL spreads may not hold up and whether there is scope for more innovation in passive debt funds. Excerpts:


Has the repo rate in India peaked, or do you see it going up further?

Right now, the market is of the view that the repo rate will settle close to 6.5 per cent. We are now at 5.90 per cent and we will probably see two more hikes that will take it to 6.5 per cent. What’s driving this expectation? One theory is that the previous repo-rate cut started when repo was 6.5 per cent. So, now they could change the policy stance to “neutral” from the current “withdrawal of accommodation” only when the repo rate reaches 6.5 per cent.

While the Fed may hike more depending on their local compulsions, in India, inflation is now beginning to roll over, at least in the second half; the next year too, inflation outlook remains benign or below 6 per cent, which is RBI’s threshold. If we believe that average inflation next year is going to be between 5.75 and 6 per cent, then one can probably say that with repo rate at 6.5 per cent, the real rates will be a tad positive.


The g-sec yield curve today is much flatter than what it was one year ago. What is it indicating?

Our view is that the yield curve basically follows the market segmentation theory, wherein at the long end, the demand for longer-dated g-secs (government securities) and SDLs (state development loans) is very robust from insurance and pension funds such as EPFO, where they like the current level of 7.5 per cent. At the short end, the dynamics are different, and they are driven by tightening of banking system liquidity, higher credit offtake, lower deposit growth and the increase in the borrowing by the banking system through CDs (certificate of deposit) and commercial papers for working capital. Rate expectations are also instrumental in adjusting the level of the short end of the yield curve. So different expectations play in the short end; whereas in the long end, insurance and pension funds are rock-steady in their demand for high-quality assets at 7.5 per cent. So that’s why the curve is getting flatter.


Do you expect the current spread of SDLs over g-secs to narrow in future?

The SDL spreads had widened significantly post-Covid, higher than the long-term average, primarily because SDL supply increased tremendously. There was a sudden decline in the revenue collection and States were forced to borrow more. Now as the economy is opening up, tax collections have normalised, and the government of India is also being very generous in sharing the tax revenues with the States. So, in the first half of this financial year, we saw that States have borrowed only 60 per cent of what they had promised that they will be borrowing. Supply of SDLs has dramatically declined. One theory is that because they borrowed less in the first half, they might borrow more in the second half. Again, we don’t know that because States right now are doing well and their non-tax revenue collections have also started inching up. Now, one should see supply of corporate bonds increasing gradually, whereas the supply of SDLs would decline.


Edelweiss MF has a strong presence in the passive debt category with Bharat Bond as well as Target Maturity funds. How easy is the replication of debt indices?  

Unlike equity, where replication of the index means investing in the same stock in the same proportion, in fixed income, things are not that simple. An index may have 30 or 40 bonds, but the same bonds may not be available every single time in the same proportion. So, in fixed income, there is a concept of risk replication. SEBI says risk replication can be done if you are holding at least 60 per cent of the bond holding of the index in your portfolio. Secondly, duration of the index and the duration of the portfolio has to be within a certain band. That is +/- 10 per cent of the duration of the index. And the credit rating of the portfolio has to be similar to the credit rating of the index. So they have ensured that there are sufficient guards which will ensure that investor experience will not be significantly different than the underlying index returns. SEBI, in one of its recent circulars, has proposed an annualised tracking difference of 1.25 per cent for passive debt funds.

Higher the duration, higher is the tracking difference and vice versa. In our view, ideally, the tracking difference should have been given for various baskets — five years, 5-10 years, above 10 years. Having said that, this 1.25 per cent is probably sufficient. For a 10-year product, assuming the price value of 1 basis point is 7 paisa, on annual basis it is 125 basis points/7 — that’s close to about 18 basis points. So as long as the deviation in the yield of a 10-year product vs the index is within 18 basis points, you are ok.


With active funds being bracketed into defined segments by SEBI, passive funds have been offering scope for innovation. How vibrant is the product development on the side of the index providers for debt passives?

In the current scheme of things, passive product can be launched only if the index is approved. So SEBI has ensured that products are launched not in a haphazard manner, but in a controlled manner. To that extent, innovation will probably be something which is on a slow track. That said, this is done because the regulator wants investors to understand the underlying benchmark and they also want to see some sort of consolidation with index being followed by multiple target maturity or passive fund manufacturers. So, I think we will continue to see plain vanilla offers only and not too many exotic stuff, which will be confusing for investors.


What kind of debt funds should investors pick up today ?

Currently the yield curve is flatter, we expect to be close to the peak of the policy rates and also expect that inflation could trend lower from here. In this context, I believe that the 5-10 year segment, although the curve is flatter, is something that will provide investors with superior tax-adjusted returns, through Target Maturity funds.

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