In conversation with Anurag Mittal, Senior Fund Manager-Fixed Income, IDFC AMC
The yield on 10-year bonds in India moved up from the recent low of 5.76 per cent to 6.20 per cent in line with the rise in US yields. How do you see its trajectory, going ahead?
Bond yields moved up in India after the introduction of the variable-rate reverse repo in early January, which some participants interpreted as a reversal of RBI’s accommodative stance (although clarified by RBI in its February policy that it was an operational measure). Besides, higher-than-expected borrowing announced in the Union Budget and the rising global inflation expectations on hardening commodity prices as the economic outlook brightened after announcements of fiscal stimulus & improvement in economic activity post the vaccination drives.
How do you see the rising inflation and especially, sticky core inflation? Will it force a rate reversal earlier than expected?
Barring any exceptional price shock, we expect consumer price index (CPI) to average around 5 per cent in FY2022 & core CPI to average around 5.5 per cent. We believe RBI’s reversal would be calibrated as it tries to balance unwinding of its COVID-related extra-ordinary measures while supporting a deeper economic recovery to the pre-pandemic levels of output through an orderly evolution of the yield curve.
The market regulator recently capped the mutual fund’s investment in perpetual bonds. How do see its impact on debt MF returns?
Given the nature of the risk of Tier 1 & Tier II Basel 3 bank bonds, we believe that it was a prudent measure taken by the regulator to cap the exposure to these bonds to mutual fund schemes. As far as the valuation aspect is concerned, the current market convention is of trading these bonds at a yield to call. However, in case of the absence of trades, a callable bond has to be valued at lower the price on-call or on maturity as per the current guidelines. In case a bond doesn’t get traded, there remains a possibility that a bond may get valued as per maturity whereas, on the days, it gets traded, it may get valued as per calls. Hence, there could be some intermittent volatility in the portfolios holding AT1/T2 bonds. From a longer-term perspective, investors also need to look at the underlying credit quality of these bonds apart from the valuation impact & ensure that the allocation to funds holding perpetual or Tier 2 bonds does not form a disproportionate part of their overall allocation.
Can you elaborate on the features of your recently launched target maturity index funds?
The two target maturity index funds launched by IDFC i.e. IDFC Gilt 2027 Index Fund & IDFC Gilt 2028 Index Funds are roll-down strategies targeting a maturity of June 30, 2027 & April 5, 2028 through primary exposure to 2027 & 2028 government bonds with some residual portion in treasury bills/cash. The fund is an open-ended fund with relatively low expenses, enabling long-term investors to construct their portfolios with some predictability of maturity.
The idea behind these funds is to exploit the steepness in the yield curve especially at the 6/7-year part of the curve. We believe the 6/7-year part of the curve provides the most optimal risk-reward in a period of relatively lower money market yields due to exceptionally surplus liquidity & pressure on longer end to the high bond supply.
What type of investors should hold such funds in their portfolio?
While open-ended and high-quality debt funds have delivered reasonable returns over the past few years, one of the advantages of a target maturity fund is the predictability of maturity as well as better visibility of expected outcomes. Ideally, investors, who are looking to hold these target maturity funds till maturity date should be considering these; however, the reasonable steepness between 3-year Gsec & 6/7-year Gsec, for example, can potentially provide a superior outcome for an investor even if 3-year Gsec goes up between 125-175 bps in the next three years compared to holding a 3-year Gsec till maturity today. For more details on the sensitivity analysis, please refer to the investor presentation on IDFC MF website: https://cmsstgaccount.blob.core.windows.net/prod-idfc-website-files/2021-03/Presentation-IDFCGilt-2027-and-2028-IndexFunds_Mar21.pdf).
However, these funds come with intermittent volatility and should ideally be a part of the satellite bucket of an investor’s portfolio.
What's your advice to fixed-income investors from here on?
Left to its own devices, the bond market might keep travelling on the path of transmission unwind irrespective of the governor’s call for an orderly evolution of the yield curve. The global reflation trade has been logical in its direction of pricing although viewpoints may differ on magnitude. Some acceleration may also have been justifiable as the size of the US fiscal response picked up. However, it is still likely that the bulk of this adjustment may have run its course for now and the repricing now falls back to a more sustainable pace. RBI might need to mute (not break) the linkage between the recalibration in the overnight rate and its exaggerated transmission to higher up the curve.
The corresponding strategy for investors may involve some amount of ‘barbelling’ where alongside traditional core investments like a quality roll down products, some combination of the very short end (overnight funds, near-term deposits) and intermediate duration strategies (focussed on maturities largely in the 6/7-year area) maybe deployed to optimise on RBI’s gradual normalisation in the context of an already very steep yield curve. It is important that investors remember to weigh intermediate duration strategies with very short maturity instruments as well so that the average maturity of their investment portfolios does not rise. It is also relevant to note that these strategies account for a rise in yields over the period ahead, provide these aren’t disruptive over the timeframe. This risk can also partly be mitigated by having sufficiently long investment horizons.