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Focused On Safety & Liquidity

Dhawal Dalal, Senior VP, DSPBR Mutual Fund, believes higher interest rates will affect the credit environment of certain sectors…

Instead of rising rates further, bond dealers believe that the RBI may allow the yields on government securities to go up. This belief was strengthened in Friday’s auction of government bonds. Your view?
We believe that bond yields are closer to their peaks. I think inflation is likely to be around 8 per cent by March 2012. One of the factors affecting the inflation trajectory is the base effect and the rate hikes that took place in the past will likely have a positive impact on reducing the aggregate demand. The RBI has clearly said that they are likely to be on hold in December 2011 as long as inflation eases off. That takes care of one part of the equation. The other part of the equation is the government bond supply and the market participants will be keenly watching the winter session of parliament for signs of any upward revision in the fiscal deficit for FY2012. Market participants are anxious to find out how the government will fund the incremental deficit and how much more are they likely to borrow from the bond market. The RBI is likely to conduct OMO in late December or early January to infuse liquidity in the banking system. If the government's extra borrowing does not unnerve the market participants and if the RBI announces their plans for OMO then we do not expect the benchmark 10Y bond yield to go significantly higher than 9 per cent per annum in the near term.

And you think inflation will stabilise?
Our base case scenario for headline inflation is to trend down in a gradual manner in the medium term. Having said that, there are lots of moving parts in India’s inflation equation. For example, if crude oil prices go up further, it may push inflation even higher from here onwards as the government will have to increase the price of diesel to reduce the under recoveries. Food prices have remained stubbornly high despite a good monsoon. Manufacturing prices are also an important component in the equation. As of now, non-food manufacturing inflation is likely to stabilize at current levels.
In the calendar year 2010, headline inflation was on average above 9 per cent. In 2011, year-to-date, average inflation has stayed above 9 per cent as well.

What is your investment strategy?
Our focus is on safety and liquidity. We believe that it is an appropriate strategy for investing in fixed income. In the current macro-economic environment possibilities of credit downgrades may outweigh the possibilities of credit upgrades. In the last two years, we have seen interest rates going up by more than 500 bps. This is likely to cause some headwinds in the economic growth going forward. Higher interest rates are likely affect the credit environment of certain sectors over the medium-term. So we have to take cognizance of this fact and attempt to mitigate the credit risks in the portfolio.
We also focus on secondary market liquidity of the assets in our fixed income portfolio. Given the open-ended nature of our fixed income funds, secondary market liquidity is very important to us in the current volatile environment. We believe in the active management of all our fixed income portfolios. Our team-based fund management approach and active style has certainly helped us in the current market conditions.

Tell me something about your risk process.
We are a four-member team. We are complemented by a dedicated seven-member Risk and Quantitative Analysis (RQA) group. We have a unique model of risk management as compared to our peers. RQA’s job is to analyze and quantify different risks in the portfolio on a real-time basis and highlight them in a timely manner. They continuously analyze and quantify various risks - liquidity, credit, price, concentration etc. and share their findings with the team during our weekly meetings. This team reports directly to the President of DSP BlackRock Investment Managers. They are also responsible for monitoring various risks in our equity funds.
The RQA team’s involvement happens at a fairly early stage. Whenever the fixed income team wants to consider in a new credit, it’s the RQA team which does the majority of number crunching and credit appraisal. They meet the management, equity-sector analysts as well as credit rating analysts to get a fair idea about the company and its business cycle. They also pore over the financials, study auditor’s reports and evaluate other equally important parameters before presenting their findings.
I would also like to mention here that we have benefitted immensely from BlackRock’s fixed income risk management expertise. We have direct access to BlackRock’s vast knowledge base, credit analysts and risk management tools.

Is it not important to stress the portfolio, specially post 2008?
Absolutely. Post 2008, we have strengthened our risk-management processes both on the asset as well as liability side. Now we pay close attention to our top investors and their investment patterns. We also try to simulate the impact on our portfolios if some of them decide to redeem simultaneously. While we cannot predict their moves, it is good to have an understanding about it. It is equally important to have a balanced and diversified investor base.
On the asset side, we are quite focused on the liquidity in our fixed income portfolio, which will include the percentage of cash in the portfolio and the percentage of assets maturing in the next seven days and the next one month.
In the liquid fund, investors tend to invest for around five days. In that case, it may not be prudent to buy long assets to generate higher returns. So we follow a ladder approach. We ensure that at least one-third of our fund matures in the first month, at least one-third in the second and the rest in the third month. So there is continuity of maturity at periodic intervals. This way, the investment profile of the fund is not lopsided.
Our RQA team also does a comparative analysis of the competition on a periodic basis - their duration analysis, the attribution analysis of their performance and its components and portfolio credit risks.

Around three years ago, DSP BlackRock Mutual Fund had around 75 per cent of its assets in equity. The fixed income portfolio was not large. That has changed and the number of FMPs being offered has shot up.
Yes. DSP BlackRock’s fixed income funds have witnessed a significant growth since the year 2010. Currently fixed income funds contribute around 60 per cent of our local AUM. Bulk of our growth has happened due to growth in our FMPs. We were able to increase our market share in fixed income by offering various FMPs to the investors. We caught the upward move in the interest rate cycle right and were able to adjust our fixed income funds quickly in the rising interest rate environment. That has immensely helped our performance.

Taking the Indian scenario into concern, is it easier to manage a small debt fund or a big one?
The Indian fixed income market is yet to achieve the kind of depth in the secondary market that can make a fund manager feel comfortable running large positions without being worried about liquidity needs. For example, if he wants to raise Rs 1,000 crore by selling long-term assets in the secondary market on a given day without a significant price impact, it would be tough if not impossible. What we miss are big fixed income market participants to provide us with secondary market liquidity. There are other structural issues. Most of the market participants tend to be on the same side of the trade on most days.
Taking into account all these factors, we believe that an optimal size of a fixed income fund should be around Rs 5,000 crore.

What will be the way to add depth to this market?
I think significant amount of intermediation from insurance companies and the banking system and EPFO will help. What we have observed is that banks are happy to buy and trade in government bonds but are reluctant to do the same in other categories such as NCDs and money market instruments such as CP and CD. EPFO does not have mandate to trade as they can only buy. Insurance companies do trade but mostly on the buy side. This does not offer any third party which can offer a significant amount of intermediation.

What advice would you give investors from a short- and long-term perspective?
We are increasingly confident that the interest rate cycle has turned. Even if the RBI hikes rates in 2012 one more time, I think bond yields are unlikely to react. The month of November is critical because Rs 52,000 crore worth of supply is scheduled to take place. On top of that, in the winter session in the parliament, we will get a clear picture of the incremental borrowing that the government plans to undertake. Once that clarity emerges, the market participants will be able to position themselves accordingly.
The 10-year benchmark at 9 per cent currently offers great value. The risk reward ratio is clearly in the favor of the investor if he decides to invest in this market for a period of six months to a year. If one looks at the two-year average of the 10-year yield it is around 7.70 per cent. So if you look at the rule of mean reversion, we are looking at a 1 per cent decline in interest rates. I am not saying it is going to happen in the near term, it may take some time since the market environment is evolving and there are a lot of factors at play. Investors with reasonable risk appetite who understand volatility can also invest in a long-duration fund. Investors with a limited risk appetite should remain at the short-end of the curve such as liquid and liquid plus schemes where they will get decent returns.

HNI: High Net Worth Individual / PPF: Public Provident Fund / RBI: Reserve Bank of India / NDTL: Net Demand and Time Liability / CASA: Current and Savings Accounts / SIP: Systematic Investment Plan / OMO: Open Market Operations / bps: basis points, 100 bps = 1% / SEBI; Securities & Exchange Board of India / AUM: Assets Under Management / FMP: Fixed Maturity Plan/ EPFO: Employees' Provident Fund Organisation / NCD: Non-convertible debenture / CP: Commercial Paper/ CD: Certificate of Deposit / GDP: Gross Domestic Product