Proactive yet disciplined duration management

WF: The fund has outperformed its benchmark and category average over the short and long term horizons. What are factors in your view that are contributing to this outperformance?

Sudhir: This is a flagship fund, hence, we have not taken aggressive credit risk in this fund. There is focus on building a portfolio with high quality securities, we have limited our exposure to non-AAA papers at any given point of time (<20% at any given time). Within the non-AAA papers, the exposure has been limited to high quality AA+ and AA papers. This is the basic positioning of the fund on the credit side.

Most of the Alpha that has been generated over the years, is achieved by active duration management. For example, the fundamental view of the interest rate is deduced based on the macro-economic environment. In the last 3-4 years the interest rate cycle was very supportive (favorable to investors), thus the average maturity bucket was held higherbetween 2-4 years and the fund continued to operate with this maturity range. While we maintained our view that the interest rates would constructively taper-off over the cycle, there were some tactical duration calls that we initiated based on the near term view. Based on market aberrations, we used to alter the maturity during those specific periods, thereby trying to generate alpha for the investors.

Our interest rate view is based on thorough fundamental research on macroeconomic factors including (but not limited to) current account deficit, fiscal deficit, inflation expectation, overall growth cycle and other global factors etc., A definite strategy for the portfolio is drawn based on our conclusions drawn from such research. Our discipline to ensure that the portfolio operates well within the strategy has ensured that we outperform the industry / benchmark.

For example, quite sometime back, there was a view that the interest rates are bound to rise, hence, we stretegically decided to cut our average maturity bucket to ~1.2 -2.5 yrs. On a tactical basis, if the near term view was bullish, we would move closer to a 2 - 2.5 yrs maturity duration and incase it is bearish, the average maturity would be held at 1.2 - 1.5 yrs. In all types of markets, there are in-between phases of reversals, example, in this rising interest rate scenario, there may be scope to capture intermediate relief rally, by increasing average maturity, but we maintain the discipline to not fall into the trap by ensuring that we do not extend our maturity bucket beyond the range deduced (2 - 2.5 Yrs) based on fundamental research.

To sum-up, maintaining discipline, basing average maturity based on fundamental view and not being affected too much by short term momentum, along with pro-active duration management have been key ingredients for our ability to outperform the industry / benchmark.

WF: On an absolute return basis, the last 1 year has seen sub-optimal returns from the category (less than 5%). Can distributors and investors draw any comfort about whether the next 12-18 months will see returns going back above the 7% p.a. mark?

Sudhir: There is a need to understand this with a little bit of mathmatical example. For example, about a year ago, there was considerable post demonetisation liquidity in the system, with liquidity chasing assets, the short term instruments (upto 3 year maturity) were trading at an average yield of 6.80% - 7.10%, hence the net portfolio yield was approx 6.5% - 6.75% post expenses. However, most funds in this category were able to generate higher returns due to MTM (mark-to-margin) gains as the yields wer falling. These kind of returns were a temporary phenomenon as fall in yield had to stop due to change in macro economic fundamentals. Hence, we started trimming duration, which resulted in lower absolute returns for a short period of time as compared to peers / market. However, this short term set - back enabled us to outperform the benchmark over a 1 year horizonafter the demonetisation liquidity started getting out of the system.

The volatility over the next year may not be as severe as it has been over the last 1 year. the average maturity bucket which was earlier 2-2.5 years may now be down to 1.2 - 1.75 yrs hence reducing the sensitivity of the portfolios to change in interest rates. For example, 1-2 year papers which were trading at 6.50% - 7% had moved sharply to yield 8% - 8.5%. if the average maturity of the fund was ~2 yrs, at that point, and yield has moved up by 1.5%, the MTM would translate to 1.5% * 2 = 3%, if your running yield was 7%, then 7% - 3% = 4% which translates to average industry returns.

Given the present scenario, the running yield is definitely 1.25% - 1.5% higher, which is a positive. The demonetization liquidity withdrawal from the system was a huge factor in pushing the short term yields higher, the yields were pushed from ~7% to 8.5%. To gain a similar momentum, there has to be a push from 8.5% to 10%, which seems unlikely. The average yield of 7% itself was an extreme at a time when fundamental factors were deteriorating.With portfolio yields being higher and average maturity being lower, probability of the returns being as low as the previous year is less likely. Any short term uptick similar to last year over the next 12 month horizon is also not likely.

WF: What are the key challenges that you need to manage and overcome with respect to management of an income fund given the current challenging macro economic scenario (interest rate / currency volatility)?

Sudhir: In the past, volatility was working in investors favor, where yields were going down and they were making money, at present the volatility is not favoring the investor which has resulted in low confidence. The need of the hour is to construct a portfolio which offers lower volatility as compared to the benchmark. The fixed income portfolios are not perceived with a high volatility, hence this becomes all the more important. While you may have a tactically bullish view, there is a need to not succumb to greed, keep the volatility low by keeping the duration low. This will help us ensure that the investors do not panic during turbulent times in the market.

There are humungous changes in the fundamental factors both locally and globally, there is a need to maintain a very dynamic view on the interest rates. For eg. US economic growth recovery, FEDs (Federal Reserve) aggression towards interest rates indicate that the easy global liquidity is done away with. Global recovery has been initiated, if we were to ignore the trade wars for the moment, it can be deduced that the EMs (Emerging markets) will benefit from such global recovery.

Locally, we need to look at the other factors such as up-coming elections has made the Government turn slightly more populist, for e.g.. the MSP (Minimum Support Price) hike which is inflationary. Such aggressive moves could enhance the risk factor. Government was expecting a huge breakthrough in the form of GST with increase in revenue, however, this did not pan out as desired. If the GST revenue does not improve in the short term, then that could be source of risk on the fiscal front, since it may result in slightly higher fiscal deficit. All these factors, combined with the likely increase in Government expenditure ahead of the elections are likely to keep the market worried. Further, lack of appetite for G-sec from nationalised banks could contribute to the increased volatility which calls for cautious trading.

WF: In your view how will the interest rate / currency volatility pan out over the next 6 – 12 months? How will this impact the performance of your fund / bond market?

Sudhir: Market is likely to remain highly volatile. Fiscal pressures continues to remain elevated and hence is a cause of worry. The year before last year, the Government was able to stick to its fiscal target, however, last year they slipped on their target. This is indicative of the fact that government may have reduced flexibility to lower its expenditure ahead of important elections. This is one of the main source of risk especially ahead of elections. The demand supply dynamics also seem to be off-the-mark, there is an increased supply of debt papers (higher funding demand) coming from higher central government borrowing in 2nd half, State Government supply, increased government serviced bond supply from PSU issuers. With LOUs being banned, we are seeing more offshore funding shifting onshore as thereis a shift from fee-based lending to fund based lending, results in increase in overall credit demand. These aspects can result in unfavorable demand supply scenario for the debt market. Also, global factors such as the trade war scenario (impact on EM currency), pick-up in inflation expectations with growth pick-up, FED move on interest rates etc., could pose some risk.

Ahead of elections, there could be some volatility, due to speculation on whether there will be a stable / coalition Government.

Given this aspect, we foresee volatility in the next 6-12 months, hence, our strategy is to remain at the lower end of the yield curve, where there will be contained volatility in absolute terms. Focus remains on accrual with an aim to avoid too high durations.

WF: The fund holds ~67 securities while the category average is 61, the holding over the past 12 months has been as high as 84 securities. What has been the rationale behind holding the number of securities (balancing diversification)? How does the interest rate scenario affect the number of securities held at any given point in time?

Sudhir: The number of securities held is just incidental. Since this is a fund with more than Rs. 10000 cr AUM, it may not always be possible to deploy money in few limited securities due to unavailability of bigger lots at times. Decision to invest the liquidity is taken primarily based on fundamental view and number of securities purchased may be high when there are multiple securities available in smaller lots.

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