‘Going by the RBI’s comments, we should assume the rate cycle is over’

Radhika Merwin

The government’s commitment to stick to its fiscal glide-path could be a positive trigger for the bond market, says Suyash Choudhary, Head-Fixed Income, IDFC Asset Management Company. Excerpts:

The RBI had in its previous policy highlighted possible upside risks to its inflation target and chosen to keep rates unchanged. Is there any room left for further rate cuts?

In our view, the RBI has run a noticeably high real rate stance, as measured by 1-year Treasury bill minus average CPI over the past year.

This has been all the more remarkable given that we experienced a reasonable growth slowdown over this period, largely unsynchronised with many other major economies.

The massive accretion to our forex reserves during this time, to a large extent owing to foreign inflow into the bond market, also bears testimony to the attractive real rates that we have offered over this period relative to global perception of India risk.

Nevertheless, the RBI has chosen to be more conservative with rates, possibly choosing to focus more dominantly on the central bank’s role as a risk manager given the possibility of higher global volatility in the time ahead.

Given this context, and in light of the recent commentary in the October policy, one should assume, for all practical purposes, that the rate cycle is over.

Even if domestic inflation numbers turn favourable and offer some headroom for a rate cut, will external factors play spoilsport? Globally, and in particular in the US, central banks are looking to end monetary easing measures.

It is clear that external factors should be accorded topmost priority.

Having said that, there are limited negative spillover risks to us so long as the US yield curve continues to flatten into Fed unwinding.

Aside from the RBI's rate cuts, what really led to the sharp fall in G-Sec yields over the past two years was the RBI’s shifting to a neutral liquidity stance by conducting OMOs, and the aggressive buying of government securities by PSU banks post-demonetisation due to excess liquidity. With both these factors no longer playing out, what is the outlook for G-Sec yields, which has of late started to inch up?

In our view, there have been three significant triggers for the rise in bond yields over the past few months: the hawkish RBI commentary, OMO bond sales, and fiscal uncertainties.

While we don’t expect any dovish change to the RBI commentary, there is still a likelihood that the bulk of the OMO bond sales is behind us.

Also, it is probable that the worst fears on the fiscal front don’t come true, given that the Finance Minister has indicated that the fiscal glide-path must be maintained.

These could turn out to be positive triggers for the bond market, especially given the context of a substantial adjustment that has already happened to yields.

The assets under management of low-rated bonds have gone up sharply in the past year or so as investors chased credit opportunity funds for higher returns. Are lower-rated bonds in bubble territory? Is there a growing risk within this category of funds?

The remarkable growth of credit-oriented funds over a very short time certainly throws up some questions.

To us, the most relevant of them is this: do Indian investors suddenly understand credit risk a whole lot better, which is why they prefer credit-oriented funds, or are they simply moving away from the explicit volatility embedded in a duration-oriented product and, in the process, maximising the portfolio yield that they can get?

If the latter is true, this may impact expectations down the line.

Investors intuitively know now how to control for duration risk, given the long period experience they have with such products and owing to the fact that risk in such products gets explicitly manifested via daily NAV movement.

However, the experience with credit is relatively new and explicit attention must be paid to control for this risk as well, commensurate with the underlying risk appetite.

The other question is whether the liquidity, price discovery, and availability of hedging tools are evolving in line with the growing assets under this category. We don’t think they are.

What kind of debt funds would you recommend to investors?

Debt funds can largely be segmented based on two types of risks: interest rate risk and credit risk. Since most fixed-income investors have converted from bank fixed deposits, the largest pool of investments should go into those debt funds that control both duration and credit risk.

This largely includes ultra-short term, short term, and medium term funds of conservative credit quality. In what proportion they deploy under such funds really depends upon individual risk appetite.

For the rest, and with a longer-term view in mind, one can add duration and credit risks. These can be done via active duration-oriented funds and select credit funds respectively.

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