Against the Tide

Santosh Kamath oversees fixed income investments at Franklin Templeton Investments and has over 15 years of investment and research experience. In this interview with Mutual Fund Insight, he shares his views on various issues ranging from CRR cut, inflation and the interest in G-sec funds in recent times. He also cautions investors against following the trend of investing in FMPs and dynamic bond funds.

What was your reaction to the last CRR cut?
Given that RBI had traditionally indicated that CRR will not be used as a liquidity tool, we thought the probability of a CRR cut was low. We felt that the RBI would use dovish language and indicate the direction they wanted to move in the coming quarters. A segment of the market was expecting a CRR cut and the high systemic liquidity deficit seems to have forced the central bank’s hand. At the time of the announcement, the interbank liquidity deficit was around Rs 140,000 crore, much higher than RBI’s stated comfort zone of 1 per cent of NDTL (around Rs 60,000 crore).

Is the market more concerned with how the central bank is going to deal with liquidity rather than when the next rate cut is to take place?
Markets are impacted by both liquidity and rate direction. From a liquidity perspective and over the near term, tight systemic liquidity leads to expectations of increased OMOs, leading to a rally in G-secs. We witnessed a sharp rally whenever there was an announcement of an OMO against market expectations. The reverse was the case when the CRR cut was announced and the market expected a stop to OMOs. Also the increased FII interest has contributed to the rally in G-secs. Once systemic liquidity normalises, RBI might stop OMOs and the near term rally could stall. Over the medium to long term, the movement in G-secs will depend on the interest rate direction.

And what is that direction?
Despite the weakening growth trends, the RBI has been wary of reversing the rate hikes due to the high fiscal gap and structural supply-demand imbalances. Policy statements indicate the tightening cycle is behind us, though the timing of reversal rests on government efforts to control the fiscal deficit and sustainable moderation in inflation. The central bank will keenly watch the upcoming Union Budget for measures on these fronts.
There could be further liquidity enhancement measures including continued OMOs and another CRR cut, given the expected year-end pressures on systemic liquidity until March. Today the systemic liquidity is around Rs 90,000 crore and once that reaches RBI’s comfort of 1 per cent of NDTL, the OMOs are likely to stop.

You don’t see rates falling?
No, we do not see interest rates coming down in a hurry until there is clarity on various fronts. While the RBI might use OMOs and CRR for addressing liquidity issues, any cut in interest rates will be predicated on reigning in the fiscal deficit and a sustainable fall in inflation levels. Core inflation is likely to remain firm despite the headline numbers and once the base effect wears off, we need to consider global factors. While the near term direction is positive for the markets due to the fall in headline inflation and ongoing OMOs, this could change few months down the line. Having said that, the RBI might look at easing interest rates if GDP/IIP numbers move down significantly.

What is your view on inflation?
Headline inflation numbers should continue to taper due to the base effect in the coming months, but we remain concerned about the core inflation drivers. The RBI has also pointed out the same given that non-food manufacturing inflation remains high. Core inflation situation got exacerbated due to the weakness in the rupee since August, but this factor has turned since the rally in the currency in 2012 so far.
Despite the slowdown in global economic growth in 2011 and fall in demand, energy prices did not come off meaningfully due to geopolitical events in the Middle East. In recent months, we are seeing positive data emanate out of US and decent manufacturing data from the rest of the world. This means that there is a likelihood that input costs will remain at current levels and could appreciate putting pressure on inflation numbers, once the base effect starts wearing off from the second half of 2012. Overall, we are not very comfortable with the inflation situation and the government needs to undertake structural reforms to address supply-side issues from a long term perspective.

You think the RBI was right in hiking rates to combat inflation?
It is clear that the central bank was trying to manage inflationary expectations, given that the linkage between interest rates and inflation levels is rather tenuous. If the impression was that the RBI is doing absolutely nothing, then inflation could go higher as expectations of price hikes would rise. They had probably misread the situation in 2010 as being driven only by supply side issues and global commodity speculation. However, as the impact of demand pressures became clearer, they started tightening rates to anchor inflationary expectations.

Do you see the fiscal deficit as worrying? Won’t a large fiscal deficit crowd out private borrowing?
Yes, we remain concerned about the fiscal deficit issue that has led to increased government borrowings in the second half of FY12 and can impact borrowing costs for Corporate India. Various factors such as expenditure, slowing revenue collections, absence of divestments and fuel-related subsidies are adding pressure on the government’s balance sheet. We need to see if the government will defer some of the under-recoveries to next year. A fresh auction of the recently cancelled 2G could potentially benefit the government. The RBI has rightly pointed out that its interest rate stance and quantum/timing of rate cuts will depend a lot on the fiscal plans of the government. In that sense, the upcoming Budget will be keenly tracked for clarity on fiscal consolidation program that has gone off track since the 2008 global crisis. We also need to see the exact impact of the Food Security Bill and track the situation surrounding the losses at the SEBs. If there are no credible plans, India’s sovereign ratings might get impacted.

Last year you had stated that monetising the fiscal deficit was alright if the economy was growing. Have you changed your view?
In a growing economy, a fiscal deficit is normal as the country looks to build its infrastructure and capacity. Monetising fiscal deficit for this objective is fine from a medium to long term perspective. However, if the expansion in fiscal deficit is primarily due to non-planned expenditure and increased consumption, monetising the same does not help.
The OMOs being done by RBI currently are done to address systemic liquidity issues. The central bank is auctioning on one hand and buying on the other hand through OMOs.

Is the dip in non-food credit due to risk aversion by banks? If that is the case, the CRR will not help…
We don’t see the fall as a result of risk aversion amongst banks or due to liquidity. Deposit flow remains healthy and we haven’t seen any increase in risk aversion like in 2008, which pushed up spreads sharply. If we look at the spread on NBFC paper today - it is around 25bps over a bank CD, far lower than the 300-400 bps levels we had seen in 2008 when risk aversion spiked. For us, the dip is due to the macro economic conditions. Private sector borrowing has reduced given the ongoing slowdown in growth and delays in project execution.
Also there is a bit of statistical anomaly here - the low credit growth numbers are also due to the high base effect with last year’s numbers being boosted by the 3G auction. If we strip out the one time impact of the same, non-food credit remains quite healthy and in line with the prevailing economic environment.

Why has Franklin Templeton as an AMC stopped coming out with FMPs?
Our experience with the FMP segment after 2008 indicated that it did not make sense given the passive nature of the products and also the low margins. As a fund house, we focus on active management and look to add alpha. Also given the regulatory changes in terms of information disclosure, we were not able to meet client expectations of providing model portfolios. During this period, we had focused on building the pure long-term fixed income business and have had success with many of our products such as Templeton India Short Term Income, Templeton India Income Opportunities Fund and Templeton India Corporate Bond Opportunities Fund. These products help us cater to investor needs through actively managed open-ended debt funds.

Is your Income Opportunities Fund a dynamic bond fund?
No, the portfolio construction is based on a bottom up approach of credit analysis and identifying sweet spots across the yield curve. For example, since its launch it had taken exposure to corporate securities as spreads had gone up due to perception issues on the companies and we took exposure across the yield curve. In 2008, the spread of PTCs went up very high because the perception was that PTCs were risky, but our research indicated that they provide good risk-adjusted returns to the portfolio without diluting the credit profile. Also when CD levels became high and NBFC spreads came down sharply, we altered exposure to these segments. In future, if the spreads between G-secs and corporate bonds reduces significantly, we can add exposure in that segment.

Why is it that you do not have a credit opportunities fund?
No. We feel that the bond market structure in India and the various laws are not conducive for such a product. The liquidity for such securities is not high and the laws are not robust enough to facilitate a smooth process for dealing with a default situation.

If you have an opportunities fund based on spread, why not have a dynamic fund based on varying maturities?
As mentioned above, we believe that a bottom-up approach works better rather than taking a top-down call based on maturity or duration. While we do factor in interest rate direction while deciding on the maturity of our portfolio, there are various other factors such as liquidity, supply-demand, spreads and credit profile, which are important for our investment process. A dynamic bond fund is ideal for investors who are looking for high conviction views on interest rate direction. This is fraught with risks as we had seen in 2008/early 2009, when many market participants had gone long in terms of maturity, which proved be a wrong move in hindsight. Also the dynamic funds in the country don’t just play on maturities, but tend to take calls on credit as well. We are working on a product that will help investors sail through interest rate cycles, which we believe is a better construct than the current offerings in the market.

In today’s environment, what should investors buy tactically?
This would depend on the investor’s objective and investment horizon. Those who have a positive view on G-secs can tactically take exposure to gilt funds, but need to be ready for heightened volatility. We have always advocated that any investment needs to be part of an overall asset allocation plan targeted at achieving goals rather than trying to time the market.

What kind of funds should investors go in for now?
As always, this will depend on the investor’s objective, risk profile and investment horizon. For those with a one-year horizon, a short term fund should work and those with a longer view (say 18 months) can look at products like our Income Opportunities Fund. It is very important for investors to match their investment horizon with the fund’s mandate, otherwise there will a mismatch of expectations and reality. Investors should also be careful while trying to get exposure to the latest trends - for example, there is a lot of interest for G-sec funds in the current environment. However, these investors should be ready for increased volatility as interest rate outlook is clouded by the fiscal deficit and core inflation issues. If the outlook changes and monetary easing gets pushed back, there is a possibility of negative returns and they should be ready for that. After all, the long term gilt funds tend to have maturities of 10 years and investors should not be looking at these for their 1-year objective. Those with a longer time frame can opt for open-ended income funds. Because then even if he gets part of the interest rate cycle wrong he is invested in it to capitalise on the next cycle.
One should also look at consistency of investment style - in our funds, the positioning is clearly articulated and we do not drift away from that. For instance, our short-term income plan will not take exposure to long-term corporate bonds. So last couple of months we have seen yields on such bonds coming down, but you will still not find a 5- or 10-year corporate bond or G-Sec in this portfolio.
Overall, given the underlying inflation trends and the expected evolution of the fixed income market in India, we believe that Indian investors who have traditionally had a low exposure to fixed income funds can benefit from increased exposure. This also helps in creating a well balanced investment portfolio.

CRR: Cash Reserve Ratio / RBI: Reserve Bank of India / G-Sec: Government of India Securities / OMO: Open Market Operations / NDTL : Net Demand and Time Liabilities / FII: Foreign Institutional Investors / bps: basis points, 100bps = 1% / SEB: State Electricity Board / GDP: Gross Domestic Product / IIP: Index of Industrial Production / NBFC: Non-Banking Finance Company / CD: Certificate of Deposit / 3G - Third generation spectrum sale to telecom companies / AMC: Asset Management Company / FMP: Fixed Maturity Plan / PTC: Pass Through Certificate