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The Future of Debt

Santosh Kamath, debt fund manager, Franklin Templeton, tells Vibhu Vats how the Indian debt market will be impacted by domestic and international factors

Santosh Kamath, debt fund manager with Franklin Templeton, tells Vibhu Vats about the future outlook for the Indian debt market and how it will be impacted by domestic and international factors.

Santosh Kamath, debt fund manager with Franklin Templeton, tells Vibhu Vats The Future of Debt

Having cut interest rates in the recent past, the RBI seems to have gone into a pause mode. Do you think this will impact debt fund returns?
Ever since the present RBI Governor assumed office, he has clearly mentioned that the RBI looks very closely at data before taking a call on rate cuts. This, I believe, will continue to be the case. Hence, I wouldn't say that the RBI is in a pause mode.

But before we get into how interest rates will impact debt funds, we have to first understand that over the last year or so, a lot of variables have turned positive and supported the Indian economy. The first of these variables is international crude oil prices, which came down very sharply. India benefitted directly from this because we import close to a billion barrels of crude oil every year. Our gold imports also came down substantially because of government restrictions. And a slowing economy led to other non-oil and non-gold imports coming down as well. Along with these, we saw inflation coming down and the new government presenting a decent Budget. So overall, these five-six variables fell into place at the same time and came in very handy for fixed-income markets.

But now, the worry is that some of these variables seem to be changing tracks. For example, oil prices have bounced back a bit, a weak monsoon is threatening to inch inflation up and there's some talk that the government may take some steps to shore up its people-friendly credentials in the aftermath of recent events. Moreover, the currency is taking a hit primarily because the US economy is doing well and also because the rupee has appreciated in nominal terms when compared to the currencies of competing partners, which makes our exports less competitive. So, the five-six parameters that were looking very positive are suddenly starting to look a bit negative now.

I believe that the RBI will want to keep a close eye on these parameters before it cuts interest rates again. Indeed, it might hold on till things start looking better. This is why I said that the RBI is data-dependant, even more so now because many of the favourable parameters might change track. And yes, coming back to your question, this will definitely impact fixed-income returns.

Investors shouldn't expect a repeat of the last year's returns. There is a remote chance that oil prices will come down sharply again, or the US economy might not pick up as expected, or that the monsoon will turn out be very good, because of which we will get bolder rate cuts and aggressive fixed-income returns. However, that's an extraordinary scenario. The ordinary or likely scenario is that the RBI will wait and watch data, and fixed-income returns will be lower than last year's.

Of the variables that you've mentioned, do you believe that oil prices are a major factor? Didn't inflation come down because of the drop in oil prices?
Yes, oil is a major factor. But so is currency. If the currency remains stable, it provides a high US dollar yield on the common bond. This will also bring more FII flows because FIIs will be very happy with the relatively higher 8 per cent yield in India. But the currency could start depreciating if the US economy starts doing well, Fed starts increasing rates, or because the Indian currency has appreciated in nominal terms compared to our competing partners. These are, of course, not in our hands. So oil and currency are both very important. If both these variables move against us, then we should be prepared for a long pause on rate cuts. But if they are stable, then we can expect a 25 to 50 basis points cut in the next six to nine months. Right now, there's a 50-50 chance of either one of these scenarios panning out.

Last time around, debt fund managers were expecting a rate cut but the interest cycle suddenly reversed in July 2013. Can this happen again?
When we look at the fact sheets for June and July 2013, we believe that we, at Franklin Templeton, were lucky because we were sitting at very low maturities in our income funds. Maybe it was coincidence or maybe it was foresight; maybe it was both. But what happened at that time highlighted a major problem in the way fixed income is managed in India - the fact that many market participants don't follow the index, which makes it difficult to get a reference point for maturity. We have no clear idea about how long is long duration.

Hypothetically speaking, if there are three fund managers who are all positive about the market, and one of them increases the portfolio maturity to seven years, the other might increase his portfolio maturity to eight years and the third to nine years. Seeing the two, the first manager will then increase his portfolio maturity to ten years. This is what happens because there's no index to set a benchmark upon. This is a very high-risk strategy because in a good market, you tend to keep increasing portfolio maturities. In a similar scenario, in the equity market, if the fund manager is bullish about the IT sector and the index has a 10 per cent weightage to the sector, heshe may go up to 12 per cent or 13 per cent, never 70 per cent. This is because market participants don't follow the index necessarily, which may prompt them to take an extreme call in both cases. In a bullish market, managers will go with long portfolio maturity and lower the maturity significantly in a bearish market. There's a lot of risk associated with any kind of extreme call.

Last time as well, in 2013, you'll be surprised to see how long some portfolio maturities were. The same thing is happening today. A couple of variables changing track can impact fixed income funds adversely. So, if you ask me if there's a chance of something like mid-2013 happening again, I would say there is some chance of that happening, but not to the same extent.

In such a scenario, what would be your strategy going forward?
We are slightly more risk-averse than other fund companies in terms of portfolio duration or maturity. Our G-sec fund is running longer maturities because it is easy for a fund manager to exit from G-secs as they're liquid by nature. But our income fund is running a very moderate maturity as it is extremely difficult to exit from a corporate position if markets turn. Therefore, we are more comfortable with moderate risks.

So, if one were to choose between a debt with a long maturity and one with a medium maturity, what would be your recommendation?
What I would recommend would depend on the investor's time frame and investment objective. An investor with the objective to earn decent returns without too much volatility should invest in medium-term corporate bond funds. These funds don't have long portfolio maturities and deliver higher yields without the investor having to worry about the interest rates.

But a short-term opportunistic investor can consider a fund with a slightly higher duration, albeit not very high. Moreover, such investors should be cautious about the parameters turning unfavourable in the near future and should also be able to withstand volatility.

Ideally, a debt fund investor should have a time frame of at least 36 months because he can then benefit from the tax advantage on long-term capital gains from debt funds. For such investors, a high-yield corporate bond fund with a medium-term maturity would make the most sense.

Gilt funds now quote a one-year return of around 17 per cent. Can this return be sustained next year as well?
That looks unlikely. If one has to calculate the break-up of where this 17 per cent return would come from, one would have to look at a portfolio yield of around 8 per cent, and capital gains of 10 per cent, so that the gross returns would be 18 per cent and net returns would be 16-17 per cent after deducting expenses. But for a 10 per cent capital gain, interest rates would have to come down by 100-150 basis points. The chances of this happening are very remote. So, if investors are looking at making the previous year's 17 per cent returns this year too, while investing in gilt funds, there are chances that they may be grossly disappointed.

Is this the greatest risk in gilt and income funds? Because if you see the previous year's returns, they're not going to come now.
The calculation I just illustrated is a very simple way of figuring out why gilt funds may not be able to repeat last year's performance. But I'm not sure how many people actually do this calculation. They just look at past returns and blindly believe that India is doing great and fund managers are doing great. Very few people know that there was an unprecedented fall in G-sec yields in the past one year, which doesn't happen frequently. Hence, they shouldn't expect the same kind of returns in the near term.

Any other risk that you see in gilt or income funds?
We have registered large inflows from FIIs over the past couple of years. What no one knows is how FIIs will react if things go the adverse way. Any reversal of flows from them can impact the markets severely in the short term. We have never seen such high FII holdings in the fixed-income market before. So, this risk is a very high risk that investors should be aware of.

Talks about the US Fed raising interest rates are ripe. Will this impact the Indian debt market?
As I mentioned before, the biggest risks for us are oil and currency. The other key risk is that of normalization of US monetary policy by the Federal Reserve. If the Federal Reserve hikes interest rates earlier than anticipated, it will be because the US economy is doing well. And if the US economy does well, the US dollar will keep appreciating and our currency will tend to depreciate. Hence, a rate hike in the US can definitely impact the Indian fixed-income market.

Do you have any special strategies in mind that you will undertake if rate hikes happen in the US?
We should be able to cut the portfolio maturities in our G-sec fund as per the market's movements even though we are sitting on long maturities. This is because G-secs are quite liquid. As far as the income fund is concerned, it is not easy to shift positions when you're holding long-term corporate bonds, which is why we have been sitting on medium maturities in it also.

Would you like to add something for our readers?
All investors should understand is that it is very risky to invest in any fund by only looking at past returns. What could happen going forward matters more than what has happened already. My message to all investors would be to not only look at past returns. This is neither a good strategy in fixed income funds, nor in any other asset classes like equity or real estate.