Prefer short term plans over corporate bond funds

Sanjay Shah

Head – Fixed Income

HSBC Mutual Fund

Sanjay expects calm to descend into fixed income markets after two RBI rate hikes. The shorter end of the curve is where he sees the best opportunities, particularly the 2 to 3 year segment. Sanjay believes that short term income funds are a better risk adjusted opportunity compared to corporate bond funds as the incremental yield on corporate bonds does not justify incremental credit risk and higher expense ratios.

WF: Was the RBI Repo hike of 25 bps expected or did it catch the market off-guard?

Sanjay: The hike was on expected lines, market was prepared for the rate hike. Even on the neutral stance, there was anticipation that the RBI would not make any changes. Market does not expect a series of hikes, there is uncertainty around inflation numbers, global factors like oil and trade war. At the moment, RBI is neutral, which means it can act on either side based on the movements of these macro-economic indicators. If inflation comes down, RBI could look at cutting rates, although this may not necessarily be the base case scenario.

WF: The last 12 months have seen very significant volatility in the fixed income space, leading to considerable nervousness among distributors and investors. How do you see the road ahead over the next 6-12 months and what will be the key drivers?

Sanjay: Over the next 6-12 months, we expect RBI to be data dependent. They may allow the last two rate hikes to trickle down into the system over some time. As Dr. Acharya suggested, policy hikes require time to take effect in the market. Hence, the rate hikes are likely to show their effect over the next 6 to 8 months. Inflation and other macro indicators could move based on the ripple effect caused by the rate hikes. In all likelihood, over the next six months (till December, 2018), we may not see RBI hiking the rates further. Also, given the front-loaded policy of RBI with two consecutive hikes in rates, there could be a calm in the market as compared to when there is an anticipation of rate revisions (when they are likely to be jittery). This could translate to lower volatility in the markets.

WF: How do these factors impact the yield curve – the short end and the long end of the curve?

Sanjay: In terms of short end of the yield curve, it is pricing in one more rate hike as of now and hence, is elevated. Further, the domestic flows are lower compared to the demand – supply requirements, this has also caused elevation in the markets. The demand – supply mismatch is pretty prominent in the short end of the curve. Given that the carry is very high, 2 to 3 year segment of the curve looks attractively priced.

In the longer end of the curve, yield after first hike was at 8%, after the 2nd hike it is at 7.70%, the yields have remained subdued despite 2 hikes. The higher rate at 8% after first hike can be attributed primarily due to the International scenario, currency rates volatility and also the lack of clarity from RBI on how they intend to handle the liquidity scenario. However, RBI, in its recent announcement, provided assurance that the liquidity scenario will be managed by Open Market Operations or OMOs and short-term repos. They will provide ample liquidity to the system, this has provided assurance to the market that they will not be getting into a scenario of deficit liquidity, which would have prompted yields to move further up. The factors such as relatively stable global cues and liquidity scenario have influenced the long end of the yield curve to come down to 7.70%. Long end of the yield curve is likely to be range bound, we may not see a big rally, it could go down to 7.60% levels, but may not dip further.

WF: How concerned are you about inflationary pressures building up in the wake of the coming elections and the consequent MSP hikes and other sops that may be on their way?

Sanjay: It is only a perception that inflation could see a spike due to the upcoming elections, there is no empirical evidence to substantiate this claim. The Minimum Support Price or MSP hike has been estimated to have an impact on inflation to the extent of 10 to 30 bps, which is not a major impact. In the wake of elections, GST rates on various goods have come down which is deflationary. Hence, this factor could be a balanced one unless, the Government decides to spend substantially by providing subsidies, sops etc., and the current scenario does not indicate of any such fiscal spend. The Central Government has not made such spend in budget, which could potentially translate to an inflationary scenario. Hence, we are not worried of an inflation flare-up on the backdrop of elections.

WF: The demand – supply dynamics with respect to funding has been distorted with the ban of LOUs (more offshore funding shifting onshore). How do you perceive this factor to affect the debt markets over the short – medium term?

Sanjay: Credit demand has spiked in the short term; credit growth is faster relative to deposit growth. However, there are new avenues which are being discovered. Formal funding methods such as corporate bond market, where the large corporates are expected to go to bond market to the extent of 25%, which is currently being mandated, could soon be effected. This means that many new alternative funding sources will be developed over time. Being a developing nation, the cumulative savings may not be sufficient to fund our investments or credit demand. There will be continued dependency on FDIs, foreign borrowings and ECBs. Further, the interest rates are higher in our country, with hedges there will be opportunities to borrow from other countries as well. There is more effort to discover other formal routes of borrowing to overcome the setback due to ban on LOUs.

WF: HSBC Short Term Income Fund has outperformed the benchmark consistently, what is the basic premise / principles for investment with respect to this fund? How are you structuring the portfolio to ensure that you make the most of the gains that you anticipate?

Sanjay: With respect to HSBC Short Term Income Fund, the focus is to lower volatility. The investor class that invests is particularly on the lookout for lower volatility with respect to returns. We achieve this by two means.

First is credit allocation – given that there is always a demand for higher YTM and at the same time, the quality of credit is also pursued. We particularly look at investments with higher YTM without compromising on credit quality. Despite many investments offering higher yield at the cost of lower credit quality, we prefer not to compromise on our basic tenet of investing only in high credit quality securities. Our focus is always to buy a bigger corporate investment or higher quality security with some potential for higher yield.

Second is position on yield curve - The second principle that we adhere to is that we position on the yield curve, we do not distribute across the yield curve. Currently, we are positive on the 2 to 3-year segment and to some extent on 1 to 2 year segment. An overnight rate is at 6.5%, whereas AAA 3-year bond is available at 8.40% - 8.30% levels, the spread it quite substantial. This spread is what we are looking forward to lock in. As stated earlier, there could be only one more rate hike, rather than a series of rate hikes. This gels well with the investments within our portfolio. These segments are going to benefit (2 to 3 years) has the benefit of 1 roll down, since the securities will become 2 year from 3 year and 1 year from 2 year, the yields will also come down. Getting the carry of the spread 1.70% to 1.80% will benefit the investors. The positioning on the yield curve benefits in outperformance of the fund.

WF: You stated that the short end of the curve is where the opportunities lie, what are the funds distributors should be focusing on – short term income fund or corporate bond funds?

Sanjay: The short-term income or short duration funds have the benefit of higher YTM, stable rate scenario and it also plays on the yield curve as indicated earlier. Two things are panning out with respect to Corporate funds / credit risk funds –

  • There is risk of downgrade of credit rating and higher credit defaults (many investments were downgraded) and
  • The YTM of lower rated funds have not gone up as expected for various reasons such as corporate borrowers are unwilling to borrow at higher rates.

The spread between a short duration fund YTM and credit risk fund YTM is as low as 50-60 bps. For the investor it may not make sense to go for a credit fund which comes at a higher risk but not with a correspondingly higher yield.

Also, the credit risk fund’s expense ratio is typically higher. Hence, this may eat into the spread, thereby leaving the investor with only higher risk but no adequate compensation. Hence, short term or short duration fund is preferred citing the above reasons.



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