Betting on rate cuts

Maneesh Dangi says Birla Sunlife Dynamic Bond Fund's strategy relies squarely on the fundamental analysis of all domestic and global factors influencing the rates and credit quality within the country.

What is your outlook on interest rates in India?
The benchmark rate in India is lower by 150 bp since the beginning of the easing cycle in Jan 2015. There is a high probability that further fall in rates would be lower in quantum and not as rapid. However, this does not hold true for the debt market securities as the impact of these rate cuts have not been transmitted completely. Given the current valuation, liquidity infusion promised by the RBI and low growth environment across the globe, we anticipate rates will drop by another 30-50 bps without any further rate cuts from RBI over the next 12 months.

More importantly, there is a case for rates to come down structurally over next few years, as the government's fiscal discipline and administrative reforms, RBI's inflation targeting and subdued commodity prices will pave way for lower inflation and therefore reduced interest rates over the next 2-3 years.

What is your framework of taking a duration call?
Gains from duration are swift and difficult to time. Therefore any aggressive addition or reduction of duration from the portfolio is preceded by thorough analysis of the domestic and global macro economic factors. Simultaneously, we create forecasts for all the crucial domestic indicators to build a probabilistic risk reward framework to examine the case for duration. The final stage involves choosing an appropriate instrument such as government bonds, corporate bonds, interest rate derivatives to achieve the target duration.

In multiple scenarios, this analysis suggests low probability of meaningful shift in rates and hence the portfolio does not alter duration. However, when the investment team is convinced of a potential move in rates, we seldom get swayed by technical factors and stay focussed on the fundamental merits which support the case for lower or higher rates.

Each portfolio manager also focuses on absolute and relative valuation of securities. The volatility in valuation presents regular opportunities for a tactical increase or decrease in duration to generate higher returns for the investors. However, these trades are a small portion of the portfolio and follow a strict stop loss discipline with respect to time or market levels or both.

What is your framework of taking a credit call? What kind of credit risk you don't take at all?
Our guiding principles for underwriting credit risk in our portfolios have evolved over time. We like companies who have seasoned across multilpe business and liquidity cycles. We like entities that belong to sectors that have already defined regulations and strong regulators. In most cases, we draw primary comfort from the investee company itself i.e. we evaluate if we would lend to the company unsecured. However, as part of our due diligence, when we sight certain risks to the investment, we build risk mitigants in the form of (i) collateral that is identifiable and easily enforceable. (ii) covenants. These are tailor made for each and every company.

We prefer companies that are part of large diverse groups. Hence, we may invest in smaller companies of a large group with moral / economic / strategic importance to the promoter where otherwise, a similar standalone company we may have avoided.

We prefer companies which belong to sectors that are all weather or non cyclical in nature. We do however opportunistically invest in companies in a cyclical sector, but those investments are underwritten only when they are pro-cyclical trades. We also scan through the borrowing history of companies to ensure that they act honourably.

In your view, how should a long-term fixed income investor optimize his returns?
Investors would derive great benefit by examining the long term performance of funds as well as fund managers. Focus on short term performance of 1-2 years does not completely reflect the investing capability of the fund manager and the return potential offered by the portfolio mandate. This analysis should be repeated annually for all existing and future allocation.

Investors should regularly plan all cashflow requirements before any major investment under specific tags such as within 1 year, 1-3 years and over 3 years. Knowing the potential timing of exit from their consolidated fixed income investments in advance would help optimize allocation across different mandates and improve longevity of their investments.

Corpus which could be deployed for over 3 years could be deployed in the schemes which have the ability to extract from both credit and duration opportunities. Investors would also do well to assign this portion to the high risk strategies.

Over-diversification could also hurt the long term performance of investments. Investors would do well to identify just one or two schemes for investment under each tag.

What will you attribute the above average performance to?
While the portfolio mandate for Birla Sun Life Dynamic Bond Fund is complex on account of the additional degrees of freedom on credit and duration, the investment approach followed has been consistent and simple.

The fund strategy relies squarely on the fundamental analysis of all domestic and global factors influencing the rates and credit quality within the country. This combined with the focus on long term performance ensures that the fund rarely shies away from high confidence long term bets in lieu of reduced short term volatility. The investment team also brings in a great understanding of history, which is important to rank different opportunities available in the market and to differentiate between short term moves and structural shifts.

Ultimately, the scheme benefits from the inputs of multiple subject matter experts within the investment team, ensuring compelling opportunities from different segments of the market such as the money market, government securities, corporate bonds, structured credit, derivatives are available to the fund manager. So while the portfolio adopts a top down approach to change risk profile depending upon the macroeconomic analysis, individual investments are vet by experts in a bottom up style.

The performance is also supported by the able execution of a seasoned trading team, ensuring the portfolio investments are rejigged swiftly when the team's expectation from the market and economy changes.

Please click here to read the analysis of this fund.

This article was originally published on June 21, 2016.