Fixed Income Markets & Strategy of Duration Funds

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1 Fixed Income Markets & Strategy of Duration Funds Market Update: July 2017 Positive bias on favorable macro data releases, awaiting further cues from RBI policy in August. At the start of the month, bond yields reversed the declining trend seen post the last RBI s policy and minutes on the back of higher global yields. Euro yields moved much more than the US yields on the back of comments by European central bankers which seem to suggest that they are looking to increase interest rates sooner than later and also start their balance sheet unwinding process due to improvement in economic conditions and higher inflation. RBI also announced a surprise OMO bond sale because of which bond yields sold off in anticipation of further bond sales by RBI to suck out permanent liquidity from the banking system. Further the Indian Government cleared the implementation of HRA allowances for 4.8m central government employees. This led to initial hiccups as HRA implementation is deemed to be inflationary in the short term. The positive trigger came during the mid month when headline CPI print came in with a sub 2% print while Core Inflation surprised on the downside to multi year low at 3.8%.This triggered the downwards trend in bond yields. Further global yields also supported the fall, as dovish commentary by US Central banker that neutral interest rates are likely to be much lower than previous economic cycles, which saw global yields fall sharply. The central banker also hinted that movement towards neutral rate requires only few hikes. FPI inflows surged post the event which negated the OMO sale announcement by RBI. Short-end yields fell sharply on the back of belief that RBI will do a rate cut in August which has led to steepening of the yield curve. Long-end yields remained stable and range bound as RBI sold bonds to absorb excess liquidity. Towards the last week of the month, global yields retraced upwards led by German Bunds as Germany s inflation was higher than estimated and ECB minutes indicated that it may not extend its balance sheet expansion beyond December While Fed minutes revealed that members are a bit unsure of when to raise rates and normalise its balance sheet, the higher Euro area yields did push US yields higher. Even as global yields increase, Indian yields have been rather insulated as FPI flows and expectations of rate cuts in the upcoming policy saw 10yr Gsec yields trade in a narrow range of 6.42%-6.47%.The 10yr GSecs ended the month at 6.47% vs 6.51% a month back. Indian bonds continue to remain an attractive asset class for overseas investors with CYTD inflows at more than USD13bn. FII inflows in domestic bonds continued to be robust. The lower than estimated inflation print and the anticipation of muted inflation prints in the next few months did lead to a decline in domestic yields. INR continue to gain against USD on buoyant flows in debt and equity markets during the month. Also the appreciation can be explained by a relatively weaker US currency which led to EM currencies gaining against the USD.

2 Market View: As expected in the August monetary policy, RBI has delivered a 25 bps rate cut and has softened its tone to Neutral from its previous ultra hawkish policies. It decided to remain cautious and data dependent for future policy actions. RBI clearly acknowledged the fact that some of the upside risks to inflation have either reduced or not materialized. Also, second successive year of normal monsoon, governments effective food supply management, sustained softer than expected core inflation and supportive global commodity price outlook could help to offset some of the medium term inflation risks. It highlighted some medium-term risks to inflation from potential fiscal spillovers as a consequence of implementation of farm loan waivers and a possible increase in HRA allowances by states which could push headline inflation by an additional 100bps above the baseline estimate over the next months. According to our view, CPI inflation will remain benign in the next few months but is likely to rise towards 4% by the end of this year after incorporating the one-off inflationary impact of the HRA allowances. With the Fed likely to start their balance sheet unwinding program in October, the RBI probably will prefer to be on the sidelines during the October policy meeting deferring the decision of any rate action in the December policy. As CPI inflation prints will continue to remain within RBIs comfort zone (4% target) even after incorporating the impact of HRA allowances, GDP growth to lag broad market estimates & FEDs balance sheet reduction program to be non market disruptive, this will open up room for further rate cuts. As with previous policies, the RBI s preferred approach is to wait and watch for incoming data and evaluate the sustainability of the inflation trajectory in achieving the 4.0% headline CPI inflation target. The comfort demonstrated on inflation trajectory is encouraging. While the RBI mentioned that it was comfortable with slightly higher real interest rates given the twin balance sheet problems - Corporate deleveraging and Bank NPAs, the growth concerns have started figuring in Monetary policy and hence we expect further bps rate cuts in this financial year end. On liquidity, RBI announced no additional measures (like the SDF) and it stated that it would continue to use existing policy instruments to mop-up surplus systemic liquidity. We remain constructive on Indian bonds, as absolute levels remain attractive, demand supply dynamics will remain favorable and domestic liquidity will remain in surplus. We expect bond yields to ease from medium term perspective as market starts pricing in rate cuts in subsequent RBI policies and demand supply to take precedence in the short term. We do not foresee any major swings in yields unless commodity prices rally significantly further or US yields jump materially. We clearly expect spread assets to outperform going ahead & curve to bull steepen as carry remains attractive at the shorter end of the curve. We also expect that the RBI's current monetary policy stance will continue to provide support to the USD/INR currency pair and inflows will continue in Indian equity and bond markets. Also USD weakness will continue aiding USD/INR pairs outperformance.

3 Rates View: We expect curve to steepen from medium to long term perspective. With the above view, we expect varying parts of the yield curve can fetch attractive returns over the next 6 12 months, albeit at various point of time. Current Rate Expected Rate (by March 2018) Repo Rate 6.00% 5.50% % 10 year GSEC % % 10 year AAA Corp Bond % % 2-5 year AAA Corp Bond % % 2-5 year AA Corp Bond % % Risks to our View: GST impact on Growth & Inflation: GST can be disruptive in short term and can have negative impact on growth. Also its inflation impact is unknown. GSTs impact, though transient in nature can distort macro readings of the initial few quarters. Farm Loan Waiver Impact: The biggest risk to markets is Fiscal slippages of states. A few states have already announced farm loan waivers and market is waiting to get clarity on funding of the same. Centre has clearly indicated that States would have to use its own resources to meet the funding requirements for farm loan waivers. Also GST compensation from centre to states will define the exact revenue stream of states going ahead. Thus a few states might have fiscal slippages for this year and SDLs supply for a few states can increase in case of revenue forecasts mismatches by states. Changing of Financial Year end: Changing of financial year end to December end from March end, might lead to preponement of spending & extra spending by the Centre as well as States and might lead to bunched up supply of GSecs & SDLs in the market. FX Volatility : With ECB also starting its tapering talks & FED indicating its balance sheet reduction plan, it can temporary lead to FPI outflows and some volatility in the USDINR pair. Fund Strategy: Long Duration Funds: Reliance Dynamic Bond Fund, Reliance Income Fund & Reliance Gilt Securities Fund Reliance Income Fund & Dynamic Bond Fund: Our Bull Steepening view has clearly played out post the Neutral policy stance. In light of our current market view and expectations of positive incoming macro data, we intend to maintain our current duration ( years) mainly through GSecs across our funds.

4 We have benefitted through spread compression between the liquid GSecs (2027 & 2029 maturity benchmark papers) and the illiquid Gsecs ( maturity GSecs) as around 30% of the portfolio holdings was primarily into maturity GSecs. We clearly would like to continue with the current strategy of steepener view and running moderate duration going ahead. Liquid GSecs would be run as a tactical exposure in our funds. Further in light of the farm loan waivers announcement by different states and the lack of clarity on its funding, we won t add to any higher maturity SDLs exposure across our schemes & tactically play the spreads with illiquid GSecs or high grade corporate bonds till further clarity emerges on the same. Post the neutral stance in policy and positive outlook, we intend to maintain moderate duration around 6.5 years going ahead as we expect another rate cut by end of this calendar year and relatively softer stance by RBI in the upcoming policy. Thus as per our Core view, we would continue to run 50 70% GSecs & rest into high grade corporate bonds. Reliance Gilt Securities Fund: In Reliance Gilt Securities Fund, the strategy is similar to other longer duration funds as last month, the fund had increased exposure to liquid Gsecs & shorter maturity GSecs by reducing the tactical exposure to spreads assets like Normal SDLs and UDAY SDLs and will run higher duration between years. The fund is currently overweight on 5yr 10yr maturity GSecs & and intends to run such positions going ahead.. Since the policy was on expected lines with no major surprises, we intend to run the current strategy going ahead. Long Duration Funds Portfolio Details as on 31 st July 2017 Asset Allocation Asset Type Reliance Dynamic Bond Fund Weightage Reliance Income Fund Reliance Gilt Securities Fund Government Bond including SDLs 62.90% 69.71% 95.59% Corporate Bond 28.70% 21.86% - Money Market Instruments and Cash & Other Receivables 8.39% 8.43% 4.41% YTM % 7.01% 6.83% Wt. Avg Maturity Yrs 11.01Yrs Yrs Mod Duration 6.35 Yrs 6.48Yrs 7.32 Yrs 1 The weighted average YTM displayed above is for the invested amount of the portfolio (i.e. excluding other receivables) For the entire portfolio weighted average YTM, i.e. including other receivables is 7.03% (RDBF), 7.10% (RIF) and7.06% (RGSF).

5 Reliance Regular Savings Fund Debt (RRSF-Debt): The investment philosophy of this fund is to generate alpha by investment into credit assets at attractive yields and spreads in the 2-3 years horizon without carrying high duration (not above 2 years) in the fund. The portfolio is well diversified on issuer, rating and maturity parameters so as to manage credit risk and illiquidity risk in the portfolio. The portfolio on a rating basis is broadly allocated into ~58% is invested into bonds with rating profile of AA and better than AA (AAA and AA+), ~29% in A+/A/A-/A1 rated papers and unrated paper. We expect further credit spread compression due to RBI s endeavour to keep liquidity neutral hence will look to deploy the cash exposure in good credit assets so as to increase the gross yields of the scheme. We are maintaining duration of around 1.98 yrs and current accruals are around 8.71% levels. The YTMs/Portfolio yields have reduced recently due to easing in yields across the credit curve. The endeavor of the fund is to maintain attractive carry of the portfolio along with moderate to low duration so as to benefit in the current interest rate scenario. Given the attractive carry and moderate to low duration focus of the fund, a large part of the total potential returns over the horizon period of years will come from higher gross yields of the fund. Curve steepening and rollover benefit have added and may add to potential returns into the fund. Because of the low duration, fund volatility is also low. The fund also gives rich carry due to higher short term yields & right mix of credits. Reliance Regular Savings Fund - Debt Portfolio Details as on 31 st July 2017 Asset Allocation Asset Type Weightage Corporate Bonds 94.40% Floating Rate Note 1.11% PTC 0.94% Cash, Other Receivables & Money Market Instruments 3.56% YTM Wt. Avg Maturity Mod Duration 8.71% Yrs 1.98 Yrs 1 The weighted average YTM displayed above is for the invested amount of the portfolio (i.e. excluding other receivables) For the entire portfolio weighted average YTM, i.e. including other receivables is 8.51%

6 Reliance Short Term Fund: Our Tactical exposure to 5yr GSecs and SDLs has clearly paid off post the Neutral policy stance. In light of our current market view, we will continue to run the strategy with low to moderate duration and focus on higher accrual income at the same time maintaining high credit profile (~ 87% AAA) of the portfolio. The strategy is based on the view that current absolute levels of corporate bond yields are attractive considering rich carry across the curve. Also with RBI s current liquidity framework, System liquidity will remain very comfortable going forward, and corporate bond yield curve will remain steep. Fund positioning: The current positioning of the fund is ~72% corporate bonds (most maturities between 2yr and 5yr) and around 18% Gsecs (closer to 5yr Gsec & SDLs). GSecs are used as tactical positions and do not form part of our Core positions. Core Positions would be run by maintaining 65 85% allocation in 2 5yr corporate bonds, as yields look attractive both on absolute yield basis as well as roll down perspective. In line with our macro view and market view, we had recently (July month) increased exposure to 5 yr GSecs and SDLs by switching out of 1-2 yr corporate bonds as a tactical move to increase duration post the dovish minutes of the last monetary policy. Thus fund has benefitted with the tactical call as Bull steepening of the curve has resulted in 3 7 year part of the curve outperforming other maturities. Thus with expectation of rate cut by the end of this calendar year, taking comfort from the positive domestic incoming macro data, we would tactically run the current fund positing going ahead. As we expect the yield curve to remain steep over medium term perspective, our Core portfolio positioning will help to optimize returns through carry & roll down benefits over medium to long term. We intend to run Core Positions by maintaining 65 85% allocation in 2 5yr corporate bonds, as yields looks attractive both on absolute basis as well as on a roll down perspective. Credit quality: The fund has relatively good credit profile as around 87% of the allocation is towards AAA rated assets while rest is allocated into AA+/AA/AA-. Low Volatility & High Accrual strategy: The current gross yield of the portfolio is hovering around 7.21% with duration of 2.31 yrs making a case for low volatility, high accrual strategy and would benefit going ahead during downward correction in the yields. The fund primarily focuses on accrual income and potential capital gains. Thus fund runs good credit profile with majority of allocation into AAA credits. Also moderate duration strategy provides protection from volatility and adds benefit due to roll down and higher absolute yields make this product attractive from a 12 to 15 months investment horizon.

7 Reliance Short Term Fund Portfolio Details as on 31st July 2017 Asset Allocation Asset Type Weightage Corporate Bonds 72.24% Government Bond including SDLs 17.61% Cash, Other Receivables & Money Market Instruments 10.15% YTM Wt. Avg Maturity Mod Duration 7.21% Yrs 2.31 Yrs 1 The weighted average YTM displayed above is for the invested amount of the portfolio (i.e. excluding other receivables) For the entire portfolio weighted average YTM, i.e. including other receivables is 7.03% Reliance Corporate Bond Fund: The investment philosophy of this fund is to generate alpha by investment into credit assets at various points in time without compromising on quality of the portfolio. An active investment strategy where gross yields are maintained higher than short term bond fund category while duration is almost at par with the short term bond fund category. This provides a perfect blend of Accruals as well as Duration. The fund currently aims to invest in papers rated AA- and above. The fund would run moderate duration of around years. In the current scenario investment would be typically concentrated in assets with individual duration range of 3-6 yrs. We expect further credit spread compression due to RBI s endeavour to keep liquidity neutral hence will look to deploy the cash exposure in good credit assets so as to increase the gross yields of the scheme. Reliance Corporate Bond Fund Portfolio Details as on 31st July 2017 Asset Type Asset Allocation Weightage Corporate Bonds 94.48% Cash, Other Receivables & Money Market Instruments 5.52% YTM Wt. Avg Maturity Mod Duration 7.97% Yrs 2.81 Yrs 1 The weighted average YTM displayed above is for the invested amount of the portfolio ( i.e. excluding other receivables) For the entire portfolio weighted average YTM, i.e. including other receivables is 7.81%.

8 Fund Recommendations: Short Term Bond Funds: We recommend investors with preference for high grade investment, funds with duration profile of 2-3 years (Reliance Short Term Fund and Reliance Banking and PSU Debt Fund) in light of lower yields available in comparative products. These are the funds that would benefit from rate cuts in monetary policy through capital appreciation as well provide protenction incase of short term volatility. These are the funds that will benefit from roll down benefit due to the steep yield curve. With neutral liquidity framework of RBI, shorter end rates provide attractive carry opportunity at current absolute yields. At least from medium term perspective, we see better opportunity over liquid funds. Relatively high grade credit portfolio and moderate duration would help benefit from both accruals as well as duration. Credit Funds: For investors with credit appetite we recommend investment in our Accrual funds (Reliance Corporate Bond Fund and Reliance Regular Savings Fund - Debt) in light of relatively lower yields available in traditional savings products. In expectations of improving liquidity conditions and money shifting from informal segment to formal banking system will create demand for investment products in line with credit funds especially from accrual perspective. Investors can potentially benefit from a combination of moderate duration along with healthy accruals over next 3 years or more. Common Source: Bloomberg, RMF Internal Research, RBI PRODUCT LABEL- Reliance Dynamic Bond Fund Income over long term Investment in debt and money market instruments

9 PRODUCT LABEL- Reliance Gilt Securities Fund Income over long term Investment in Government Securities PRODUCT LABEL Reliance Income Fund Income over long term Investment in debt and money market instruments PRODUCT LABEL Reliance Regular Savings Fund Debt Option Income over medium term Investment predominantly in debt instruments having maturity of more than 1 year and money market instruments PRODUCT LABEL Reliance Short Term Fund Income over short term Investments in debt and money market instruments with the scheme would have maximum weighted average duration between years

10 PRODUCT LABEL Reliance Banking & PSU Debt Fund Income over short to medium term Investments in debt and money market instruments of various maturities, consisting predominantly of securities issued by Banks, Public Sector undertakings & Public Financial Institutions PRODUCT LABEL- Reliance Corporate Bond Fund Income over medium term Investment predominantly in corporate bonds of various maturities and across ratings that would include all debt securities issued by entities such as Banks, Public Sector undertakings, Municipal Corporations, bodies corporate, companies, etc Disclaimer: RNAM is not guaranteeing/offering/communicating any indicative yields or guaranteed returns on investments made in the scheme. The information herein below is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. Certain factual and statistical information (historical as well as projected) pertaining to Industry and markets have been obtained from independent third-party sources, which are deemed to be reliable. It may be noted that since RNAM has not independently verified the accuracy or authenticity of such information or data, or for that matter the reasonableness of the assumptions upon which such data and information has been processed or arrived at; RNAM does not in any manner assures the accuracy or authenticity of such data and information. Some of the statements & assertions contained in these materials may reflect RNAM s views or opinions, which in turn may have been formed on the basis of such data or information. The Sponsor, the Investment Manager, the Trustee or any of their respective directors, employees, affiliates or representatives do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such data or information. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and opinions given are fair and reasonable, to the extent possible. This information is not intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Recipients of this information should rely on information/data arising out of their own investigations. Before making any investments, the readers are advised to seek independent professional advice, verify the contents in order to arrive at an informed investment decision.

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