Debt funds have outperformed equity funds for the last two years. Will the tables turn in 2017?
If you look at the last 20 years broken up into four five-year periods, bonds have outperformed equities for three periods, including the last five-year period. In fact over 22 years, since we have bond-index data in India, bonds have outperformed stocks. This suggests that for long-term investors, fixed income has delivered. Having said that, we must note that we have had a large fall in rates over the last three years. The historical performance should be seen in a context where the ten-year G-sec yield has dropped about 200 basis points. Thus, while we still expect the RBI to cut rates, we must temper our expectations going forward.
Yields have fallen more than expected in 2016 due to demonetisation. At what level of ten-year G-sec, do you think the yields will bottom out?
The bond market has been quite volatile since November 8 and is now trading about 25 basis points below the pre-demonetisation level. Indian bond performance has been at variance with the rest of the world, where yields have risen sharply during the same period. The global context has also seen strength in the US dollar, while emerging-market currencies, including the Indian rupee, have weakened; commodity prices have risen. The reason for the drop in yields is the positive shock to the bond market from the expected impact of demonetisation. We believe that the RBI will cut rates going forward. However, we do not see a large down move to market yields.
2016 has proved to be a great year for long-term gilts, credit-opportunity funds and income funds. Will we see the same categories perform in 2017?
The choice of category of funds should be made keeping in mind the investment horizon and risk-taking ability. Funds in liquid and ultra-short-term categories are suitable for short-term, low-risk investments due to the nature of investments. Other funds attempt to generate superior returns in exchange for a higher level of risk - duration in the case of income and gilt funds and credit risk in the case of credit funds. Credit risk for some companies may increase if the economic impact of demonetisation is significant and lasts for an extended period of time. Thus, we are going slow in our incremental credit exposures. We expect yields on short-term instruments such as CDs and CPs to remain low in the current environment thanks to the abundant liquidity.
With RBI not cutting rates as expected in its latest policy review, are you revising your expectations for further rate cuts?
The RBI surprised the market by staying put on rates in the December review. In this, RBI appears to have reacted to the near-term risk being posed by international developments. They believe they can wait for data before acting on any potential economic impact of demonetisation. As the phase of global bond and currency volatility wanes, we should expect the RBI to reorient to domestic factors. Thus, lower inflation and weaker near-term economic outlook should lead to 25-50 bps of rate cuts.
Credit funds have delivered impressive returns in the past one, three and five years. Do you see the ratings of lower-rated corporates improving?
In the last three-five years, we have seen credit funds deliver performance similar to long-duration funds. The recent past saw duration funds outperform considerably, while credit spreads widened a little in the wake of downgrades. In general, stronger economic performance is associated with rising interest rates and credit upgrades, while a weak macroeconomic environment leads to lower rates and downgrades. In the last 12 months, we appear to have started the process of economic recovery after a prolonged slowdown. However, demonetisation presents new risks to growth in the near term. It is prudent to go slow with adding new credit funds at this point in time. If the economic impact is relatively small, we should see growth resume, improving the outlook for lower-rated credit.
How is the ongoing rout in global bond markets, with rising bond yields, impacting FII flows into Indian bonds/G-secs?
We have already seen considerable selling by foreign investors in bonds. The global rate surge is occurring on the back of expected better macros in the US and other developed markets, while China appears to be growing at a slower pace than expected. Thus, global portfolios have rebalanced to the new outlook. We believe this process of rebalancing will end quickly, after which we should see a resumption of flows. A strong global growth environment is not negative for flows as it is usually accompanied by better export performance and a strong currency.
The rate differentials between the US and Indian markets have shrunk of late. Will this trigger continued outflows?
At the time of start of the last US rate-hike cycle (2004), Indian rates were at 4.5 per cent, when US rates were at 1 per cent. At the end of the US cycle (2006), Indian rates were at 6.5 per cent, while US rates had climbed to 5.25 per cent. This implies that the interest-rate differential was in a range of 125 to 350 bps during this entire cycle of rising rates. And yet during this period, we saw the rupee remain strong, along with strong export performance and foreign inflows into our capital markets. The reason for this is that US rate increases occur because the economy in the US is strong and that is not bad news for Indian macros.
How do you think demonetisation will impact the Centre's finances and thus the G-sec market over the medium to long term?
On the fiscal front, the government should see better tax revenues, both as a result of one-time schemes and better compliance in the coming years. On the monetary front, this move has resulted in a substantial improvement in the banking-system liquidity, which should keep the system easy for several years. Lastly, there is the potential downside risk to near-term growth due to the fall in economic activity caused by currency withdrawal. All three impacts are broadly positive for bond markets and yields should remain low for an extended period. This is especially true for short-term securities, which are affected the most by improved system liquidity.
What are the risks and opportunities for debt-fund investors in 2017?
The global environment has seen a weakening currency, while commodity prices have risen sharply. This presents a risk of inflation in the medium term. The second risk comes from a slowdown in economic activity, which could affect lower-rated companies. To offset any economic slowdown, the government could go for higher fiscal expenditures, which could lead to a higher deficit and borrowing.
On the opportunities side, any economic slowdown would be very positive for long-term bonds. We have also seen credit spreads broadly widen in the wake of downgrades earlier in the year and, more recently, post demonetisation. If the economic impact is relatively limited, the higher credit spreads could be an interesting opportunity in the coming months. Lastly, demonetisation has led to a big increase in the deposit base of banks and has led to a large increase in system liquidity. This will lead to a better transmission of RBI cuts into the markets and pose an opportunity for short-term bonds.
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