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"We are in the middle of an interest softening cycle" Killol Pandya; Senior Fund Manager - Debt, LIC Nomura Mutual Fund

| 5/2/2013 9:00 PM Thursday

Killol Pandya

Senior Fund Manager – Debt, LIC Nomura Mutual Fund

  • Debt funds typically endeavour to protect capital and provide regular, albeit relatively lower returns. On the other hand, equity funds are typecast as wealth builders which aim to participate in corporate growth stories. In that sense, the fundamental objectives of equity and debt funds are different. The risk appetite of a debt investor is significantly lower than that of an equity investor – this basic fact should be kept in mind by debt fund managers at all points in time.
  • Interest rates are inversely related to prices. Therefore, as rates cool off, investments made in debt instruments appreciate and experience gains. The extent of the gains depends on a variety of factors including the nature and credit quality of the security, residual life of the instrument, etc. It is also noteworthy that incremental investments made in times of lowering interest rates earn less in terms of yields and/or coupons, thereby affecting the future profitability of the portfolio.
  • Gold, as a commodity, is more of an indicator of the mood and sentiment of investors. However, given the historical attachment Indians have had with the metal, we continue to import large quantities of gold for private consumption. In that context, the import of gold ends up being a drag on the economy and does not directly result in economic productivity.
  • Some of the broad measures which may be considered in case of the twin deficits include rationalising government expenditure and curbing non-productive demand. On the other hand, government income too may be boosted by pushing through revenue generating proposals such as those related with FDI and divestment.
  • Being in the middle of a softening interest rate cycle, rate cuts have already been initiated and it is only the timing of the future cuts that is a point of discussion. In such circumstances, I think it is a good time for investors with a medium to long-term investment horizon of say beyond six months to invest in debt instruments and products which can take advantage of the softening in interest rates.

Considering India’s long-term economic growth estimates and inflation trajectory, our medium to long-term view has an undertone of bullishness, says Killol Pandya, Senior Fund Manager – Debt, LIC Nomura Mutual Fund in an interview to Saikat Mitra

With respect to the Indian debt markets and Indian investors, how challenging do you find the fund management industry?

The mutual fund industry in India has a long history but has picked up only in the last decade or so in terms of participants and volumes. After 2008, there has been a shift in the working environment of mutual funds (MFs). While earlier, it was possible for fund houses to evolve on a narrow and low-capital based platform, the industry has since evolved into a platform fit for serious and long-term players – those who have a long-term vision as players in the domestic asset industry.

Although there have been extensive discussions on the topic, I believe that it is incorrect to say that the industry is overcrowded. The penetration of MFs beyond metros is still very poor and only a fraction of investors in India include MFs in their investment options. There is abundant scope for expansion in geographies beyond the metros and the inclusion of potential investors in the long run.

The industry environment is quite competitive. We have old and established houses along with new participants and there are still others looking to enter the asset business in India. The way ahead will bring interesting times.

What is the difference between managing funds on the debt side and on the equity side?

Debt funds typically endeavour to protect capital and provide regular, albeit relatively lower returns. On the other hand, equity funds are typecast as wealth builders which aim to participate in corporate growth stories. In that sense, the fundamental objectives of equity and debt funds are different. The risk appetite of a debt investor is significantly lower than that of an equity investor – this basic fact should be kept in mind by debt fund managers at all points in time.

At an operational level too, the domestic debt markets are different from equity markets. By and large, the Indian debt markets (especially the corporate bond markets) suffer from a lack of standardisation and depth. A lack of liquidity is the most significant lacuna in debt markets. A debt fund manager, therefore, must not only manage the credit quality of the portfolio but its liquidity as well. In fact, the crisis of 2008 was actually a case of illiquidity rather than a credit meltdown.

Do you follow any particular investment philosophy when you talk about LIC Nomura as a fund house?

The approach to debt investments is primarily guided by interest rates and their movements. Since credit risk is of primary concern, we follow a bottom-up approach for stock selection. While following a bottom-up approach to investments in debt papers, due care is taken to reduce liquidity risk as risk spreads are also evaluated to generate an alpha. Further, as the debt instruments are not standardised, due care is taken and an analysis is done to understand the structure of the instruments and the risk-return potential before making an investment decision.

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

The returns given by debt MFs in the forthcoming months will primarily depend on the interest cycle. The speed and strength of the movement by the RBI in terms of reference rates shall be the primary driver behind debt fund returns. In addition, WPI inflation, rupee movements and fiscal reforms will be watched in order to determine the expected returns.

We appear to be in the middle of an interest softening cycle. We are likely to experience a period of interest rate softening before rates stabilise. As a function of this, we would advise retail investors to stay invested in debt funds while keeping about a quarter of their monies at the shorter end of the curve (liquid and ultra short-term funds) and venture out towards products which are longer on the yield curve with the balance monies, albeit in a calibrated manner.

What do you think will be the impact on bond yields of different durations (short as well as long) when the rates cool off?

Interest rates are inversely related to prices. Therefore, as rates cool off, investments made in debt instruments appreciate and experience gains. The extent of the gains depends on a variety of factors including the nature and credit quality of the security, residual life of the instrument, etc. It is also noteworthy that incremental investments made in times of lowering interest rates earn less in terms of yields and/or coupons, thereby affecting the future profitability of the portfolio.

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

As mentioned earlier, we are in the middle of an interest softening cycle. We are likely to experience a period of interest rate softening before rates stabilise. As a function of this, we would advise retail investors to stay invested in debt funds while keeping about a quarter of their monies at the shorter end of the curve (liquid and ultra short-term funds) and venture out towards products which are longer on the yield curve with the balance monies albeit in a calibrated manner.

The bond markets have not developed as expected. What according to you has gone wrong and what steps should the government or the RBI be taking to develop it?

The Indian corporate bond market is tiny when compared to the bond markets of other nations. Corporate bonds account for only about four per cent of the country’s GDP, compared to 70 per cent in the US or 49 per cent in South Korea. Bond markets require risk-free benchmark yield instruments for pricing of credit risk.

The country does today have a large government securities (G-Secs) market for this purpose. This market has developed rapidly since 2000 and is resilient enough to absorb large orders without affecting price. But while government borrowings are huge in terms of large and regular issuances — Rs 6.7 trillion in 2011-12 — the volumes are very poor when compared to the issued stock. Not only has the turnover ratio been constant around 1x since 2004 but the top five G-Secs alone account for 86 per cent of total traded volumes. Also, benchmark risk-free yields are well established only for limited tenors, especially the most traded 10-year paper. Nor is there any great diversity in the G-Sec market participants, as 70 per cent of the stock is held by banks.

The story is worse in the corporate bond space, with about six to ten issuers dominating over 90 per cent of the volumes.

Many discussions have taken place on this topic and for a long time now, we have had various proposals on the table. Many steps need to be taken to improve the situation and while maintain transparency in reporting of trades and dissemination of the same is already underway; the Forwards and OIS markets have not taken off in an expected manner. A functioning repo market for corporate bonds is another long standing requirement which needs to be addressed. In addition, steps need to be taken to standardise corporate issuances so that they meet the needs of a larger investor base rather than serve only the requirements of the issuer.

Admittedly, the issue is not as simple as it sounds since there are multi-layered regulatory and legal issues to be considered and sorted out before we can have a coherent policy of reform implemented.

Going forward, how do you think the crude oil prices and the gold prices are panning out?

Crude oil prices have a significant bearing on the domestic markets since oil is the single largest commodity imported by India. In recent times, crude oil prices have softened somewhat but on a sustained basis, thereby giving some breathing space to the government for reducing the oil deficit as well as to the RBI by providing it with some time to focus on reviving growth.

Broadly speaking though, I think brent crude prices may remain in the USD 100 per barrel (bbl) range for now. Gold, as a commodity, is more of an indicator of the mood and sentiment of investors. However, given the historical attachment Indians have had with the metal, we continue to import large quantities of gold for private consumption. In that context, the import of gold ends up being a drag on the economy and does not directly result in economic productivity. Gold prices too have softened in the recent past on account of global cues. Nonetheless, given the nature of Indian demand, I am unable to have a long-term bearish outlook on gold and remain bullish on gold with a long-term perspective.

How fast do you think the government will be able to dissipate the twin deficit gap?

While it is a simple enough statement to make or plot as an equation, bridging the fiscal and current account gap is easier said than done. From the perspective of the economy, the twin deficits are causing severe constraints and are hampering fiscal as well as monetary policy actions. However, the government too has to balance the pressures on inflation and currency with the need for economic growth, while also following its agenda of financial inclusion and development. We should also not forget that the coalition politics entails complex situations that often lead to delays.

Having said that, some of the broad measures which may be considered include, rationalising government expenditure and curbing non-productive demand. On the other hand, government income too may be boosted by pushing through revenue generating proposals such as those related with FDI and divestment.

What is your advice to investors in the Indian markets at this juncture?

Being in the middle of a softening interest rate cycle, rate cuts have already been initiated and it is only the timing of the future cuts that is a point of discussion. In such circumstances, I think it is a good time for investors with a medium to long-term investment horizon of say beyond six months to invest in debt instruments and products which can take advantage of the softening in interest rates.

As mentioned earlier, our economy is slowing down. But given the bleak global conditions, we may continue to outperform many other developed and developing markets. Considering our long-term economic growth estimates and inflation trajectory, our medium to long-term view has an undertone of bullishness. In such market conditions, I think that for investors having a medium to long-term investment horizon, it is appropriate to go in for duration products such as dynamic bond funds, medium-term bond funds and PSU bond funds.

 

Find More Articles on: DSIJ Magazine, FM Speak, Economy, Markets, New To Markets, Investment Strategies, PSU, Personal Finance, Mutual Funds

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