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"We believe that there is room for about 75 bps cut in the benchmark repo rate through the current fiscal 2014" - Rahul Goswami, CIO Fixed Income, ICICI Prudential AMC

If the bond yield curve is likely to move from a flat 7.25 per cent across all tenures to something like 6 per cent overnight rising to 7.25 per cent for 10-year maturities, it makes sense to focus on the two-five year segment, which will really form the belly of the curve when it steepens – because this is the segment that could see the sharpest relative reduction in yields going forward.

Rahul Goswami

In the current scenario where the bond markets are expected to see a rally, duration funds can yield good returns. Rahul Goswami, CIO Fixed Income, ICICI Prudential AMC speaks to Saikat Mitra about the need to make investing in debt funds simpler, more appealing and rewarding for investors.

Debt funds are not as popular among retail investors as equity funds. As a fund management house, what are you doing to popularise debt funds?

In the quest for getting incremental institutional allocation in a competitive market, the fund industry has perhaps over-complicated its fixed income products – so much so, that few retail investors understand the offerings any longer. These are times when simplicity is perhaps the biggest virtue – a lesson well absorbed by us.

We have introduced a few products in the past few years that are positioned to the retail investors. One of these is ICICI Prudential Regular Savings Fund, a product in which we have capped the maximum subscription amount per investor to Rs 15 crore. Its key feature is that it is a 100 per cent bond fund with almost 100 per cent allocation to corporate debt, nil exposure to equity and minimal exposure to government securities.

The ICICI Prudential Regular Savings Fund is such a simple product, it’s unique just for its simplicity. The fund has seen a lot of interest from retail investors and has seen its assets under management (AUM) grow to Rs 2836.10 crore as on March 31, 2013 since the time it was launched in December 2010.

Apart from making available products that are clearly positioned for retail investors, we have recently conducted an investor awareness campaign to promote the debt funds category to retail investors. This campaign has generated a lot of interest among retail investors.
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Does ICICI Prudential as a fund house follow any particular investment philosophy?

Our investment philosophy is to follow a disciplined approach to investing, with a strong focus towards process orientation. Today, processes are an integral part of the investment framework, where the belief is that only a balance of fund management and a clear process orientation will help provide scalability and benefit all stakeholders. The key guiding principle to our investment philosophy is to maximise the risk-adjusted returns for our investors in the respective asset classes, and create wealth for them over the long-term. We have successfully demonstrated our ability to achieve this in the past, and are confident that our process-oriented investment approach will help us sustain the same in the years to come.

Based on our overall fund investment philosophy, the investment objective derived is to optimise risk-adjusted returns. This is achieved by investing in high credit fixed income securities, managing interest rate risk and minimising liquidity risk. The group seeks to achieve Safety, Liquidity and Returns (SLR), in that order of priority, while managing a variety of schemes.

Aligned to this, the priority in buying corporate bonds is safely and liquidity followed by returns. We continue to hold the majority of our portfolios in the liquid segment of the corporate bond market, thereby mitigating safety/liquidity-driven risk on the portfolio. We look at capitalising on a credit opportunity when we are opportunistically able to find a good risk-reward ratio. On a standalone basis, we are very selective as far as credit opportunity is considered, given that we manage money in a fiduciary capacity.

There have been round of talks about the cut in the key policy rates in the forthcoming RBI meet. What is your take on the interest front, and how do you see it panning out going forward?

The 10-year benchmark GOI bond yields have moved to 7.35 per cent (data as on May 21, 2013), which is a sharp down-move of around 38 bps from the April 2013-end closing of 7.73 per cent. Commodity prices have continued to show softness after a steep fall seen in the case of gold or oil. Also, in the Asian region, central banks have cut rates based on softening commodity prices, lower growth numbers and expectations of lower inflation. Locally, with lower inflation numbers and expectations of a lower GDP for FY2013, the market is expecting the RBI to continue with the rate cut in its June policy announcement as well.

The bond market is pricing in another 50 bps rate cut by RBI over the next two-three policy announcements. There is potential for the bond markets to rally further, and this is based on the expectation of the RBI continuing on the path of monetary easing based on softening in inflation and growth slowing. Also, we believe that with the recent steps taken by the government and the RBI on curbing gold demand and imports, the Current Account Deficit (CAD) should trend downwards, giving the apex bank more flexibility and space as far as monetary easing is concerned. We believe that there is room for about 75 bps cut in the benchmark repo rate through the current fiscal 2014.
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What impact do you see on bond yields of different duration (short as well as long) when the rates cool off?

It is important to understand the current shape of the yield curve and the significance of its interpretation in identifying opportunities for investors. Theoretically, the flatness in the yield curve is an indication of the extent to which the market is bullish. When the longer end of the curve comes down aggressively towards the shorter end, it is called bull flattening. Bull flattening is possible or justifiable if the collective wisdom of the market believes that the central bank is behind the curve. So, there is nothing that the shorter end of the curve will be able to do, but the longer end of the curve will bring about a compression in the short-term and the long-term bond yields. If investors believe that the central bank will be behind the curve, then it is better for them to buy the longer end and let the yields come down. Later, when the central bank action happens, the rolldown will also benefit them.

This is the reason we are seeing the 30-year bond trading at 7.5 per cent, we have the mix of old and new 10-year bonds trading at 7.25 per cent. 3-month T-bills and 1-year T-bills are also trading at 7.25 per cent. Once the market believes that the central bank is now in line with the rate cut cycle, the curve will start steepening and you will see the yields on two year-five year bonds coming down much faster than those on the longer tenure bonds.

In 2008-09, the fiscal and monetary policies led to inflation. At the end of 2009, the 1-year T-Bill was closer to 3.5 per cent and the 10-year bond was closer to seven per cent. Today, the 1-year T-Bill yields 7.25 per cent and 10-year bonds continues to trade at 7.25 per cent. Going forward for the next three-five years, my view is that the government should have fiscal policies such that inflation will remain low. Inflation in the next say three-five years should average around five-six per cent.

The average inflation in the last 10 years has been around 6-6.5 per cent, and this should be around 5-5.5 per cent in the next 10 years. So, I think on an average basis, 10-year bonds can sustain below 7.35-7.40 per cent for a long time. And as long as inflation is in the five-six per cent range, you can’t expect overnight rates to fall much below 6 per cent.

If the bond yield curve is likely to move from a flat 7.25 per cent across all tenures to something like 6 per cent overnight rising to 7.25 per cent for 10-year maturities, it makes sense to focus on the two-five year segment, which will really form the belly of the curve when it steepens – because this is the segment that could see the sharpest relative reduction in yields going forward.

What is the right strategy to invest in debt funds, especially when interest rates are falling?

Typically, long-term debt funds emerge as an appropriate investment tool as they generate superior returns in a falling interest rate environment. Long-term debt funds include income funds (which invest a majority of their corpus in government securities and long tenure debt instruments issued by corporates) and gilt funds (which invest in bonds issued by the central and state governments). The value of the underlying debt instruments in their portfolio fluctuates on a daily basis (known as market risk) due to factors such as interest rate movement and the liquidity situation. The price of debt instruments and interest rates (yields) move in opposite directions, i.e. price of the bond rises when interest rates fall and vice versa.

Studies conducted by CRISIL Research across 2000-04, 2008 and post April 2012 – cycles with falling interest rates – have shown that the returns from gilt funds were the highest across debt fund categories at 16.15 per cent, 60.12 per cent and 11.26 per cent, followed by income funds at 11.89 per cent, 34.61 per cent and 10.66 per cent, respectively. The returns were higher than those offered by bank fixed deposit rates during the same periods.

Investors should, however, be mindful of higher volatility in gilt funds as compared to other debt funds, as the former are prone to interest rate fluctuations. Income funds, on the other hand, tend to provide more stable returns in the long term and also have the leeway of taking exposure to gilts as per the interest rate scenario. Income funds also provide investors with exposure to higher rated corporate securities that trade at higher yields as compared to gilt prices, cushioning the additional risk.
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We believe that the current market conditions are likely to benefit investments in duration funds like income and gilt funds, as we expect the bond markets to rally further. Most of the recent gains have come in these duration funds. The shorter and the medium-term maturity funds have also done reasonable well.

Structurally, we see the rates moving down at least through this current financial year on account of softening commodity prices and inflation. The RBI will have more flexibility and space as far as monetary easing is concerned. Going forward, we expect the central banker to conduct more open market operations (OMO) and buy bonds in the shorter-end of the bucket rather than infusing liquidity by buying 10-12 year maturity bonds. Expectations of the RBI continuing with monetary easing by cutting rates in the future and also improving liquidity by conducting OMOs at the shorter end of the curve makes the shorter and medium end of the curve very rich and reasonably rewarding.

What would you advise investors in the Indian markets at this juncture?

Retail investors may benefit out of investing in duration funds like income and gilt funds and also in dynamic bond funds. As long as they are associated with a qualified Independent Financial Advisors (IFA), distributor and any of our channel partners, they will have access to sound advice that will enable them to invest in the right funds.

Investors can achieve their financial goals as long as they have the support of the right financial advisor. Today, advisors are well educated and have scientific methods towards investment. Our advice is that the investors should talk to their financial advisor, explain their risk profile and requirements and accordingly take appropriate risks that suit their investor profile.

On a risk-adjusted returns basis, we feel that it is best to invest in the two-five year maturity segment of the yield curve. This is suited for the best risk-adjusted returns and also mitigates the reinvestment risk arising out of a falling interest rate scenario. Products like the ICICI Prudential Regular Savings Fund and the ICICI Prudential Short Term Fund focus on this maturity segment.

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