INDIA INTEREST RATES: CHANGING GEARS 2017 was a volatile year for the interest rates markets. Expectations built at the beginning of the year of a sustained low interest rate regime got increasingly questioned as we entered the last quarter of Calendar Year 2017. Benchmark 10 year yields after stabilizing in the 6.40%-6.60% range during mid year, have shown a sharp jump of 80 bps to 7.25% - 7.35% in the last 4. While the shorter end was stable till recently, they have caught up with the up move in G- sec yields in the last 2. The 1 year CD (Certificate of Deposit) rates have moved up by 50 bps and the 3 year high grade (AAA) bond yields have also inched up by similar margins to trade currently at 7.20% and 7.50% respectively. We analyze the main reasons for this move, some of which have exceeded our expectations as well, and also put forth our views and strategies as we get into 2018. The Macro Picture: The secular bull rally in the interest rates was primarily driven by continuous macro improvements. Barring CAD (Current Account Deficit) which mainly benefitted from a fall in crude prices, in terms of Fiscal Discipline and Inflation we saw significant qualitative and quantitative improvements. The crux of the current market concerns also revolves around these two. On the fiscal side, the two major issues that have concerned the markets are a) the revenue position post GST implementation for FY2018 and how does it impact FY2019 budget and fiscal as well, b) how will the government approach FY2019 given the current and emerging political & economic environment. On the inflation side, the negativity has been primarily driven by a rise in crude and commodity prices, which are expected to seep into core and headline inflation over the next few. To be fair, most of the analysts still expect headline inflation to be well within RBI s range of 4% (+-2%) for 2018 as well. Our View: There are indications that GST revenues will see some shortfall in near term driven by compliance and infrastructure issues. This has already impacted this year s fiscal as evidenced in the extra borrowing announced in December 2017. But extrapolating it into the next year may be myopic. Once the process is smoothened there is a reasonable probability that the tax collections could meaningfully improve due to higher compliance.
Second, there is a genuine issue in the farm sector on the terms of trade, which has only been partly addressed by a good monsoon. There could be both quantitative as well as qualitative fiscal issues arising out of that focus. Only if the government consciously deviates from the fiscal path would we raise question marks given the excellent track record of the last 4 years. It s important to wait for the budget numbers before one takes a view either ways, notwithstanding this year s negative surprise. On the inflation side, it can be fairly expected that inflation will remain in the RBI s range. Positive surprises especially in terms of inflation stabilizing below 4%-4.5% are difficult from here on, unless we see a sharp pull back in commodity prices. Going forward, seasonality will bring down food inflation, the HRA impact will start fading post December, but the adverse base impact will get over only in June 2018. In such a scenario, RBI would continue to remain cautious. Unless inflation sustains above the 5% - 5.50% mark for a prolonged period, we may be in for a long pause. The Liquidity Dynamics: Demonetization added unprecedented liquidity to the banking system. At the peak of demonetization, core liquidity reached Rs 9 lakh crores. Since then liquidity has gradually mean reverted with the latest core liquidity numbers at Rs 2 lakh crores. This is still a very comfortable scenario as far as bond markets are concerned. While the demonetization excess is behind us, the other key focus area has been the dynamics of external account impacting domestic liquidity, namely CAD and capital flows. While CAD has reversed trend owing to higher commodity prices, it has been well funded by foreign direct as well as portfolio investments. If the global and local economy continue their recovery trends into 2018, the balancing act may continue. Our View: Liquidity conditions have a bearing both on the levels as well as the shape of the curve. We expect core liquidity conditions to continue to mean revert and stabilize around 1% of NDTL (Net Demand and Time Liabilities) that RBI is comfortable with. At the margin, given still below par aggregate demand conditions, the RBI may be happy providing some excess liquidity in the system to keep lending rates low and encourage credit growth. A strong currency will also add to sterilization related liquidity infusions. In such a scenario, we will expect the curve to remain steep, at least in the 0-5 year segment. There could be temporary dislocations at the extreme short end, due to seasonality and/or year end dynamics, but the broader trend will be for a steep yield curve.
What are the markets pricing in? The sharp reaction in yields clearly captures the following market expectations: 1) No further rate cuts. 2) Fear of rate hikes a. in case commodity markets continue their uptrend, b. and inflation stays above 5% mark sustainably. 3) Confidence in the global growth cycle. 4) Inflation will catch up / exceed global central bank targets. 5) Domestic fiscal policy will be looser as we go into 2019 elections. Specifically the markets are already pricing: 1) 2 rate hikes as per the swap curve, 1-2 rate hikes as per the cash curve. 2) Balanced to slight surplus liquidity conditions. Can yields move higher? Given the sharp uptick in yields, with the 10 year benchmark crossing 7.25%, the market is clearly pricing in a lot of negatives. The 125 bps of spread over repo rate has been sustained only during few periods of fiscal imprudence. As mentioned above the swap curve is already pricing in 2 rate hikes in CY 2018. For yields to move meaningfully higher than current levels, the bar seems high. One, the domestic demand story is still uneven and needs some form of monetary support (rates and / or liquidity). A large part of the recent credit expansion has happened through capital markets and related entities which will be very susceptible to liquidity and yield conditions. Second, the base case for India is a broader sustenance of the current macro environment and not any significant deterioration from here on. Both from a fiscal and inflation perspective, the 2 nd half of FY2019 can have some positive triggers. The track record of the current government on both these counts has been much better and hence being excessively negative is not warranted. Third, the developed market yields are already pricing in reasonable assumptions of potential rate hikes and the largest economy, the US is already in the 8 th year of an economic expansion. In fact there is unanimity on very strong global growth prospects for CY 2018, and some negative surprises are very much possible. Finally from a pure technical standpoint, a lot of the recent up move in both G-Sec and especially the corporate bonds have been exacerbated by adverse demand / supply and excess positions being unwound. The adjustment process may continue in near term, and then stabilize.
How to position for 2018: Fixed income securities deliver returns through a combination of the following: 1) Carry 2) Level of interest rates (Movement in the underlying curve) 3) Term structure (Steepness of the yield curve) In an environment where the visibility of interest rates moving lower in near term is limited, where the best in terms of improvement in domestic macro is behind us, and liquidity conditions are neutral to positive, carry, neutral duration and potential roll down strategies should be the mainstay of investor allocations. Duration play could at best be tactical for now, with a revisit towards the second half of FY 2019. Also, as witnessed in recent times, interim volatility makes it important for investors to map their allocations to their holding period as much as possible in order to avoid negative surprises. The two way movement of rates and seasonality in liquidity should not be ignored. Finally, while investors will have views and mandates around the credit risk that they are comfortable with, the focus should be on maximizing carry within those thresholds. As corporate India mends its balance sheets, it may be worthwhile going beyond the pure AAA / Sovereign space, and within AAA to look at more private sector AAA exposures including structured AAA exposures. Recommended s: Name of Nature of Rationale Ideal Holding Period Gross yield (%) as on 31.12.17 Duration (yrs) as on 31.12.17 Reliance Money Manager Ultra Short Term Attractive carry, meaningful protection from volatility due to the steepness in the 0-24 month curve 3-6 7.55 0.77 Reliance Medium Term Aggressive Ultra Short Term Attractive carry, meaningful protection from volatility due to the steepness in the 0-24 month curve 3-12 7.89 1.18
Reliance Floating Rate - STP Short Term Passive Roll down strategy, hence diminishing duration risk 12-36 7.74 2.11 Reliance Short Term Short Term Neutral duration strategy, low reinvestment risk, benefits from steepness (0-5 years), attractive carry post recent correction 12-36 7.86 2.26 Reliance Corporate Bond Moderate Duration Corporate Bond Neutral duration and higher carry, returns enhanced through potential spread compression 18-36 8.65 2.74 Reliance Regular Savings Debt Option Accrual Higher carry, returns enhanced through potential spread compression 36 9.28 2.08 Reliance Dynamic Bond Duration Moving to neutral duration territory of 3-5 years, long duration allocation to be tactical, carry enhanced through higher allocation to private sector AAA bonds. 18-36 7.73 4.88 Source: RMF Internal Research, Bloomberg, RBI PRODUCT LABEL Reliance Money Manager Income over short term Investments in debt and money market instruments
PRODUCT LABEL Reliance Medium Term Income over short term Investments in debt and money market instruments with tenure not exceeding 3 years PRODUCT LABEL Reliance Floating Rate Short Term Plan Income over short term Investment predominantly in floating rate and money market instruments with tenure exceeding 3 but upto a maturity of 3 years and fixed rate debt securities PRODUCT LABEL Reliance Short Term Income over short term Investments in debt and money market instruments with the scheme would have maximum weighted average duration between 0.75-2.75 years PRODUCT LABEL Reliance Regular Savings 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 Corporate Bond 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 PRODUCT LABEL- Reliance Dynamic Bond Income over long term Investment in debt and money market instruments Disclaimer: The information herein above 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
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