In good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place, even though it turned out to be not needed.
– Howard Marks
Every investor scrutinizes the relationship between risk and reward before entering an investment. The risks associated with equity investments are well understood – over time, risks even out, while rewards accumulate. But, what about debt?
Markets work in cycles. People often ignore that debt works this way too. The monetary policy determines the trajectory of interest rates in an economy. Interest rates could trend downwards, bottom out and move upwards again until they peak and begin to descend. The interest rate cycle is what makes debt markets cyclical. Typically, when inflation is benign, and growth looks dull, interest rates are cut to stimulate the economy. On the other hand, when inflation rises and liquidity increases, interest rates are raised to cool the economy. Clearly, the interest rate cycle is linked to economic growth and inflation.
We can expect interest rate cycles to shorten. The RBI has a mandate to target inflation and keep it at 4% (+/- 2%). So, inflation is clearly range bound. In a growing economy like ours, inflation is the key determinant for interest rates. Consequently, even interest rates will be contained within a band.
Playing a shorter cycle requires an altogether different approach and can be quite challenging. Mitigating risk should be at the core of the investment strategy. Constructing a sensible portfolio takes time and involves a significant amount of preparation. The current market scenario may be more favourable to debt investments in terms of the risk-reward metric. Sensible allocation to debt could help construct a well-rounded portfolio.
Our focus has always been on quality. This helps us effectively manage risk. We offer solutions customized to our investor’s risk appetite and investment horizon. Our strategy involves analysing trends in the debt market and taking advantage of market volatility to construct a layered debt portfolio.
Explore your asset allocation options by fixing an appointment with our team.
Bond markets may witness volatility over the next few weeks. Debt portfolios could see notional losses because of this. Portfolios can be protected by sticking to instruments with shorter maturities or by either holding investments until maturity. Fresh investments should be made in a phased manner, taking advantage of market opportunities.
A rate hike seems more likely now than ever before. Inflation is undoubtedly the centre of monetary policy decisions. The upward pressures to inflation (oil prices, disposable income, government policies, etc.) are gaining momentum. Oil prices still loom as an obvious threat. well-distributed monsoon is good for the economy. When growth prospects improve so does disposable income. Minimum Support Prices (MSP) will play a key role in determining the inflation trajectory.
The MSP is the lowest price at which the government purchases crops from farmers. The MSP is set at the beginning of every sowing season and is not based on the actual market rate. It is central to the government’s agriculture policy. The purpose is to encourage crop production, secure farmers’ financial interests, and provide food security. The efficacy of MSPs on these parameters can be debated, but our objective is to explore its effect on bond markets.
A higher MSP obviously means an increase in food prices for end consumers. This automatically means an increase in food inflation. Since the intention is to secure farmers’ interests, we could see a spurt in rural incomes. Discretionary spending moves in tandem with the rise in disposable income. An increase in spending translates to a rise in inflation. The policy could also increase the fiscal deficit.
If inflation rises, the RBI may resort to hiking rates to cool the economy. A wider fiscal deficit may lead to more government borrowings. These factors could cause bond yields to move up and induce volatility in the debt market. Caution is the watchword.
Uncertainty often induces fear in financial markets. Developments in the local and global economy leave room for rate hikes. If bond yields rise, longer-term portfolios will be impacted the most. The sensible choice would be to focus on diversifying risk through asset allocation and investing in high-quality instruments.
As far as debt markets are concerned, there is little visibility on the way forward. Globally, central banks are adopting diverse methods to deal with the challenges of their economies. Domestic concerns are centred around inflation and crude oil prices. The RBI is justified in maintaining a neutral stance amidst so much uncertainty.
The US economy appears to have regained strength, evidenced by economic growth and employment statistics. Concerns that short-term yields are inching closer to long-term yields (flattening of the yield curve) are not deterring the Fed from following its course towards hiking interest rates. Historically, this has been an indicator of economic recession.
Meanwhile, the ECB seems to be adopting a more measured approach. It has committed to wind down its Asset Purchase Program by the end of 2018. It is in no rush to tinker with interest rates and may only begin raising rates a year from now. For the ECB, the focus is on maintaining favourable liquidity conditions and keeping inflation below the 2% limit.
Of mounting concern is the United States’ trade war with China. While the US may appear to have the upper hand, it will deal with its fair share of blows in the form of rising inflation, job loss, and lower profitability. Financial markets are already reacting to the rising tensions and the effects of any trade war will not be isolated to China and the USA alone.
Volatility has struck debt and equity markets in equal measure in 2018. Valuations continue to remain an area of concern with respect to equity markets and volatility will continue to persist until earnings match valuations. This is a global phenomenon and is not restricted to domestic equity markets. Meanwhile, investor appetite for debt has reduced.
Our core strategy team has been working on attractive investment options within the fixed income space. Our strategies are expected to outperform traditional investments like fixed deposits (one-year) by 1% to 1.5%. Hedging your portfolio through proper asset allocation will help mitigate risk. To explore your investment options please get in touch with your relationship manager.
Positive growth indicators and tame inflation are facilitating the Fed’s policy to hike interest rates. Globally, advanced economies are expected to follow the same cue. Interest rate hikes across the board could induce volatility in emerging markets like ours. More importantly, threats of a trade war, rising crude oil prices, geopolitical tensions, and protectionist sentiments could further pose threats to stability. Currencies are expected to weaken, as countries compete for exports and try to manage deficits.
The RBI’s neutral policy implies that a data-driven approach will be followed when it comes to managing the economy. Any adjustments will be made in a calibrated and gradual manner. The focus is on resolving stressed assets, improving transmission of policy rates, keeping inflation within the target range, and fostering an environment for higher economic growth.
Bond yields have remained at elevated levels for a variety of reasons. The government breaching its fiscal deficit led the market to believe that there would be an oversupply of government bonds. Markets anticipated that the government would borrow more heavily in the current year. However, its announcement to restructure the borrowing program by following a more staggered approach using instruments of varying maturities has pleasantly surprised investors.
The recent scheme recategorization has created a more transparent and investor friendly system to understanding the classification of mutual funds.
Risk management always plays a central role in any investment strategy, especially when it comes to debt. A well-constructed portfolio should be able to weather uncertainties and deliver returns. To discuss hedging strategies through asset allocation, do feel free to reach out to our team.
With higher uncertainty in debt and equity markets, this would be the time to review asset allocation and manage risk. There is now an opportunity to construct a layered debt portfolio. A phased transition out of ultrashort-term funds into high-quality accrual funds may be warranted.
This policy indicates that the RBI has greater visibility into inflation and growth projections and are comfortable with the current stance and policy rates. While near-term inflation is on the higher side, the central bank expects inflation pressures to stabilize in the coming financial year. Rising crude and commodity prices will continue to push inflation upwards, but a normal monsoon and controlled food supply will moderate this effect. Further, oil prices have moved both ways in the recent past, making it difficult to be certain that they will remain at elevated levels.
The reserve bank has continuously cautioned against fiscal slippages. Last year, farm loan waivers were a concern. This year, it is the government’s fiscal deficit target. Fiscal slippages increase inflation and lower creditworthiness and will have a bearing on capital flows.
Across the world, bond markets are correcting. Advanced economies are witnessing higher yields now. For instance, the yield on the 10 Year US Treasury is trading close to 3%. A weaker dollar has caused oil and commodity prices to rise, increasing domestic inflation. All these global factors have contributed to the rise in domestic yields.
Both SEBI and RBI will request larger companies to finance 25% of their borrowings from the market. Bond issues for the bank recapitalization, affordable housing, NHAI’s infrastructure projects can be expected. The government has indicated that a debt ETF will be launched similar to what was done for the Bharat 22 ETF in the equity space.
The Return of Deposits:
The exempt income from interest for senior citizens has been increased from Rs. 10,000 to Rs. 50,000. In addition, TDS on deposits has been removed. This effectively makes fixed, recurring, and post office deposits more attractive for senior citizens.
Rising yields, interest rate hikes, and better monetary transmission are likely to improve returns for all debt investors.
Reversal Of Flows
LTCG on equity instruments has been reintroduced. Equity as an investment avenue has lost some lustre. Dividends from equity are no longer exempt from tax. This means dividend income from balanced and equity mutual funds are taxable. As optimism in equity markets moderates and there is parity in the taxation of debt and equity instruments, there might be a reversal of flows.
Debt as an investment avenue is regarded as a safe choice. The risks in debt markets are not immediately obvious. Yields have moved sharply this month, and volatility in debt markets continues. But, what role do risk and volatility play in debt markets?
Illiquid securities face little volatility, as there is almost no price discovery. It is difficult to enter or exit these investments and investors may have no choice but to hold them until maturity. While there is no fluctuation, there is risk.
Credit quality plays a central role in determining returns. Low quality pays a high price and vice-versa. The risk may be permanent loss of capital. Volatility arises from changes in ratings. Rating upgrades bode well for returns, while downgrades do the opposite.
Over the last 18 months, an unusual trend has been observed. There has been a swift and steady outflow of capital from fixed deposits into balanced funds. Fixed deposit investors have always looked towards avenues that offer fixed returns and guaranty protection of capital. Balanced funds promise neither. So, how did they become an attractive alternative to the traditional fixed deposit?
A Miracle Solution
The nature of the debt marked changed in the past few years for retail investors. Tax structures favoured equity over debt. One on hand, investors had to hold debt investments for three years to claim indexation benefits on their long-term holdings. On the other hand, dividends from debt mutual funds were issued post dividend distribution tax of 28%. Further, returns across the debt spectrum fell rapidly as interest rates fell. This ruled out debt funds from the offering.
On the contrary, equity markets enjoy zero dividend distribution tax. Additionally, long-term capital gains (LTCG) are currently exempt from tax. While debt markets hit a rough patch, equity markets have been following a one-way trajectory…upwards.
Balanced funds have been pitched as a suitable alternative to fixed deposits because they also have a debt component. Banks aggressively sold these funds to clients. This is yet another instance where banks have prioritized their revenue interests over their clients’.
Balanced funds were a miracle solution – they were offering seemingly higher returns than FDs while supposedly being safe. In addition, they are more tax efficient and were even offering to pay regular monthly dividends. Unlike interest income, these dividends are tax-free.
Balanced funds are a type of equity mutual funds that invest a minimumof 65%of the portfolio in equity instruments. This makes them an equity product. Most balanced funds currently follow an aggressive investment strategy on their equity portfolio to cope with the inflows and to deliver the promised returns. This makes them inherently ill-suited for conservative investors.
More importantly, regular dividend payouts are not sustainable. In mutual funds, dividends are paid from booked profits in a scheme. Essentially, the fund houses sell securities to book profits and this is handed back to investors in the form of dividends. It’s important to note that if the markets correct, the dividend will be paid from invested capital.
Balanced funds have been touted as the ideal asset allocation fund. However, since a majority of the investment is in equity instruments, it can’t work as a “one-size fits all” solution. The more prudent choice would be to work towards asset allocation across debt and equity. For regular sustainable cash flows from mutual fund investments, a prudent Systematic Withdrawal Plan would make more sense.
The Way Forward
A market correction could see the flight of capital from balanced funds if there is NAV erosion. Traditional investors who were avoiding the volatility of debt markets will not be able to tide through the volatility of equity markets. A sudden reversal of flows will primarily hurt investors who pull their money out, but it will also affect those who choose to stay the course.
At ithought, we have been working towards creating fixed-income solutions for our clients that are customized to their cash flow and return expectations. If you would like to explore our offerings, please get in touch with us.