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Negotiating A Changing Landscape

India’s leading fixed income CIOs talk about the complexities of debt fund management…

Fixed-income fund management is passing through an unusually interesting time. As the central bank raises interest rates relentlessly, fund managers are scrambling to stay one step ahead. In our roundtable discussion with six of the leading fixed income Chief Investment Officers of India’s mutual fund industry, readers get an insight into how investment managers are dealing with the new world of rapid rate changes and a new risk landscape that doesn’t look like becoming easier any time soon

What is your biggest concern today as a debt fund manager?
Dhawal Dalal:Everyone wants to know when interest rates will come down. Since 2010 and the early part of 2011, most economists and fund managers were expecting no more than a 100 bps rate hike. But we have got much more and it doesn’t look like the RBI is going to stop any time soon if inflation does not come down very sharply. Consequently, everyone is looking for guidance: Should we put in money now? What direction will interest rates take? Will they come down very soon? What if I miss out the cycle?

Ramanathan K:My concern is the liquidity of the corporate bond market. Corporates can really benefit if they access the bond market. Today, the base rate is 7.5 per cent, even for an AAA company, you will have a spread of 1.5-2 per cent charged by the bank. So if they borrow from the banking market, their cost of borrowing for working capital could go up to 13 per cent, and imagine what the cost of borrowing for AA, A or BBB type of company would be. Whereas 1-, 2- and 3-year AAA corporate bonds are at around 9 per cent which gives a 3 per cent benefit.
Today, from a business point of view, the sizes of corporate bond funds are pretty small. And suppose, for whatever reason, the rates crash and a lot of money flows into the income funds, the corporate bond market cannot absorb those flows, especially on the selling side. There have been a lot of committees appointed to address the problem of liquidity over the past seven to eight years. The key issue is not the number of players, but incentivisation of them. Insurance companies which have pension funds buy and hold because there is no incentive for them to trade. Though banks account for almost 70 per cent of the volumes, what is the incentive for a PSU bank trader if he makes `50 crore of profit? Incentivisation of the market participants is the key factor.

Navneet Munot:I am optimistic on the FII participation in the long run. However, if one takes a longer term outlook on the rupee as well as interest rate levels, I think India would emerge as a good market to look at. We just need some more operational efficiency in terms of regulatory clarity.

Dhawal Dalal:There are two types of foreign investors, one who actually want rupee exposure and the other looking for Indian credit. In 2008-09, post the Lehman Brothers crisis, some of the Indian credits were available very cheap, about 12-14 per cent in dollar terms. At that point in time, none of the FIIs were interested in Indian credit because they were getting paper like Tata Motors and Reliance Communications cheaper in the dollar market, that’s why the RBI allowed them to buy back some of their bonds. But recently the kind of flows we saw after mid-2010 as of now, it is pretty much at INR exposure along with higher interest rates. Looking at what has happened to the currency market, from 44 to almost 50 in a very short time period, they are all going to get shocks.

Ramanathan K:There are three components of the FII quota - corporate bonds, government securities and infrastructure. The corporate bonds quota is full and the FIIs have pumped in money. Infrastructure is empty, government securities sparingly. I don’t think the FIIs are interested in investing for the long term, they are looking at short term opportunities, arbitrage opportunities and currency plays to invest.

Rithesh Jain:You are saying that we are not strong enough fundamentally to command that type of FII flows in the long term. I still feel that the dollar, which has moved in the near term from 44 to 49 is transitory in nature, it is not going to remain at 49 for long. Specially given the fact that the fundamental difference between the US and Indian economy is going to stay. It’s ironical that the US economy which was downgraded just two months back is commanding that kind of premium. How long do you think that’s going to sustain?

Dhawal Dalal:Asian markets have always been at the receiving end. When the world has no opportunities, investors will look at Asia. Look at Indonesia and Philippines where bonds have rallied like there is no tomorrow. And now we have a situation in Indonesia where foreigners own more than 60 per cent of the bonds. They make the money and if something goes wrong they run and at that point in time create havoc in the system.

Nagarajan Murthy:Our bond market is institutional in nature, world over it is like that. But as an asset class we have not got the same benefit that others have got. For instance, the tax benefit for selling an equity investment after a holding period of one year. That induces him to invest in that asset class and not put money into bond funds.

Ramanathan K:Take the case of FMP. This simple, boring product is most attractive. On a 2-year bond, it is possible to get 9.5 per cent. This year’s inflation is very high so indexation will be high. Next year even if you assume 6 per cent, 15 per cent is the indexation benefit (9+6), and 18 per cent is the kind of return. So you pay tax only on the 3 per cent incremental returns which you earn over two years because you can get two indexations. So the effective tax rate is only 5-8 per cent vis-à-vis 33 per cent in a bank fixed deposit. Why should anybody invest in a bank fixed deposit? It is lack of awareness.

Dhawal Dalal:SEBI has refused to categorise FMPs as a separate category. If you look at the AMFI data, they don’t have FMP as a category, which is very surprising. The regulator must understand that FMP is a product viable and helpful for the retail investor.

When it comes to fixed income investing, 2008 changed our understanding of risk and sovereign debt. What do all these changes mean for your framework of managing money?
Dhawal Dalal:In 2008 we saw massive drying up of liquidity, massive outflow, FII money pushing the rupee all the way to 51-52, money market rates going back to 13-15 per cent. I think that event actually reinforced one’s ability to stress test the portfolio. At that point in time, liquidity funds used to have 1-year assets and FMPs used to have massive mismatches. Though that risk is not there, we need to keep stress testing our portfolios. What if credit goes up by 100 bps from here? What if the rupee goes to 51? What if liquidity suddenly tightens? What if 25 per cent of your fund gets redeemed in one day? What are the backups? How do you deal with that? So, it has become very important for fund managers to keep on stress testing their portfolios.

Nagarajan Murthy:The regulator has taken it’s stance that if you are classifying a fund as a liquid fund, you can’t buy more than 90 days so the maturity mismatch has gone from the system. Your average portfolio maturity is 30-35 days. The other is that market discipline has been enforced because the corporate investors know that more than 80-85 per cent of the portfolio is invested in CDs. So to that extent your risk is eliminated because people feel that banks don’t default and even in the 15 per cent space, they are all very good quality NBFCs. My concern is that many of these companies are rated P1+ for the short term. As per the norms, anything which is rated more than AA- is P1+ automatically. There are also companies that don’t have a long term rating of AA- but they have got a P1+. The long-term rating of these papers in the portfolio must also be published. That will give the investors an idea of the actual risk.

Kumaresh Ramakrishna:Most of the money that comes into the liquid fund is institutional driven. So at the end of the day investors also have become a little more savvy or a little more discriminating in terms of knowing which portfolio holds what kind of paper. Prior to 2008, most investors used to be return driven, now the risk-reward relationship clearly has come into play.