Category Archives: This Week In Debt

Monetary Policy Highlights: February 2018

 

Investment Strategy

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.

Policy Highlights

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.

Fiscal Slippages

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.

Global Factors

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.

 

 

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Budget 2018: The Debt Markets

 

New Instruments

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.

The Hidden Volatility In Debt Markets

Risks & Volatility

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?

 

 

 

Liquidity

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 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.

 

 

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From Fixed Deposits to Balanced Funds

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.

Latent Issues

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.

The Year That Was

Interest Rates & Yields

2017 opened with expectations of continuing in the trajectory of falling interest rates. However, RBI took the markets by surprise by shifting the monetary policy stance from accommodative to neutral in early February. The reserve bank has reiterated and reinforced this stance ever since. The interest rate was cut only once by 0.25% during the October policy on account of persisting low inflation.

The 10-year Government Security had a roller-coaster ride this year. Yields rose sharply when the policy stance moved to neutral. On the contrary, there was barely any movement, when interest rates were lowered in October. The yield has been on a steady rise from August this year. The rise has been supported by the RBI’s OMO operations, neutral policy, and rising interest rates in the United States.

Demonetization & Inflation

This year witnessed the after-effects of demonetization, manifested in the form of excess liquidity. The RBI has worked consistently to absorb the excess liquidity. Currency in circulation has been restored to its pre-demonetization levels. Improving GDP and industrial production numbers in the last two quarters has allayed slowdown concerns.

Inflation appears to be the lynchpin. Monetary policy actions hinge on the movement of inflation rates. The CPI index reached a concerning low of 1.54% in June this year. Over the past few months, inflation has climbed due to rising food and fuel prices, geopolitics, and increasing global liquidity.

US Bond Markets

This year, the Fed has raised rates by 25 basis points each in March, June, and December. The interest rate now lies in the band of 1.25% to 1.50%. Falling unemployment and improving economic growth in the US have supported these rate hikes. The overall expectation is that the Fed will continue to raise interest rates in the coming year as well. The passing of the tax reforms will speed up this process. Jerome Powell is set to replace Janet Yellen as the Fed Chair in 2018.
Market Outlook

2017 favoured Indian equities. To such an extent that money meant for debt flowed into equity, mostly in the form of balanced funds promising regular payouts. This is not a healthy trend for financial markets.

A rate hike is more probable than a rate cut in the current scenario. Keeping this along with neutral policy in mind, it is important to maintain quality in the investment portfolio. As the fixed income space has a return ceiling, it is important to align to high-quality accrual funds that can ride through volatility and protect the portfolio from downsides.

Recapitalization of Public Sector Banks

The Premise

The Indian Banking system has been trying to resolve its crisis of bad loans. In particular, public sector banks (PSB) have been struggling with their NPAs (non-performing assets).

There have been ongoing efforts since 2015 to address this issue. The RBI mandated Asset Quality Reviews (AQRs) that brought more transparency in determining the quality of loans. Following this, banks were expected to create provisions for their bad loans. Additionally, amendments to the Insolvency & Bankruptcy Code (IBC) and the intervention of the NCLT (National Company Law Tribunal) has sped up the loan recovery process.

However, banks remain stressed and have been unable to boost their interest inflows and grow. A healthy banking system is necessary for a healthy economy.

 

A Vicious Cycle

Banks are trapped in a vicious cycle. The NPA crisis rose from incorrect capital allocation. When a borrower defaults, the bank’s capital ratios take a hit. Subsequently, banks become fearful of taking on new loans because a default will worsen their position. By refusing additional capital, the ratios decline further adding more stress to balance sheets. On the other hand, writing off NPAs puts off new investors thereby reducing capital inflows.

 

 

 

Recapitalization

One of the ways to get out of this mess is to infuse capital into banks. The government’s proposition to recapitalize banks with Rs. 211,000 Crores doubles up as a reform initiative. Capital will be allocated based on merit, prioritizing banks who have polished their balance sheets by cleaning up their NPAs. This initiative forces banks to take real losses by auctioning off collateral, seizing assets, and absorbing losses. Thus, the idea is not to bail out banks, but to help better capital ratios and raise fresh capital. This will be structured using recapitalization bonds.

 

 

 

 

The Way Forward

Now, banks must become responsible with their capital allocation. The recapitalization bonds will have to be earned. The capital infusion will enhance the balance sheets and spur growth. Simultaneously capital allocation will improve by giving banks liquidity to lend without having to compromise on the quality of borrowers. The economy as a whole will benefit from government spending through these PSBs. The fittest banks will survive. We may even see consolidation and mergers in the PSB space, resulting in healthy, stable, large, public sector banks.

Infrastructure Bonds

What are Infrastructure Bonds?

The government of India awards infrastructure status to certain projects that are of national importance. Infrastructure projects are usually undertaken by PSU entities such as IDFC, PFC, etc. with L & T being the exception. Capital for these projects is raised through infra bonds. The minimum investment ticket is Rs. 5,000 and there is no upper limit.What are their features?

Security:
Like all bonds, these bonds have credit ratings. As the government vets these bonds, they typically have the highest credit rating. The issues may or may not be secured (i.e. backed by assets).

Taxation:
Investments in infrastructure bonds can be used to claim deductions under Section 80 C. The interest earned on the bonds is taxable.

Tenor:
Infra bonds are long-term bonds where the tenor is 10 to 15 years. The bonds are callable after the lock-in period. This means that the issuer can recall or buy back the bonds once the lock-in period is over.

Liquidity:
Infra bonds are locked in for five or seven years depending on the tenor (ten or fifteen years). However, they are exchange-traded and can be sold after the lock-in period. It might still prove difficult to liquidate the bonds as there is low market participation.

Who are they meant for?
Infra bonds are meant for investors looking to park their money in a secure avenue. Currently, there are no new issues. Returns are close to those of government securities with similar maturities. Since there are other instruments offering higher return under Section 80 C, it may not make sense to invest in infrastructure bonds solely for the tax benefit.

RBI Monetary Policy – December 2017

Stance

The RBI’s stance on monetary policy is crystal clear. In the last year, the challenges have been to manage excess liquidity, anaemic growth, low inflation, and the NPA crisis. The RBI acknowledges that any outcome is possible from this point and therefore chooses to maintain its neutral stance. Effectively, monetary policy decisions will be data-driven. Keeping this in mind, the reserve bank has left key rates unchanged.

 

The Reserve Bank’s Outlook

Central to any policy change is inflation and growth. Risks to inflation could arise from various directions. The stability in food and fuel prices has largely reversed. Volatility in food prices may be tempered by kharif output. Fuel prices in the near-term are linked to OPEC’s policy and geopolitical relations.

On the other hand, the narrative to growth remains positive. Recent regulatory reforms such as the GST (Goods & Services Tax) and IBC (Insolvency & Bankruptcy Code) have led to India’s rise in the ease of doing business rankings. The recapitalization of public sector banks is linked to reforms. This will sustainably improve capital allocation. These factors continue to enhance the environment for further economic growth.

Currency in circulation post-demonetization has expanded. Excess liquidity in the system largely rose from demonetization and the RBI’s Foreign exchange operations. Liquidity has begun to normalize and is expected to be neutral in the first half of 2018.

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Basel III Tier 2 Capital

Basel III Tier 2 Capital


Following from the capital adequacy requirements under the Basel III accord, banks’ capital was split into tier 1 and tier 2 capital. Tier 1 forms the bank’s core capital, while Tier 2 forms its supplementary capital. The instruments under Tier 2 capital are riskier as it is difficult to assess their quality and they are harder to liquidate. However, the purpose of tier 1 and tier 2 capital is to ensure that banks can absorb losses (if any) and continue functioning under periods of financial duress.

 

Tier 2 Capital:

In India, tier 2 capital consists of reserves and hybrid securities. Reserves are capital provisions that a bank makes. Hybrid securities carry features of both debt and equity instruments and may further be classified into upper (perpetual instruments) and lower capital (dated instruments).

General Provisions & Loss Reserves:
This reserve is created as a hedge against any unidentified losses.

Revaluation Reserves:
A revaluation reserve is created by reassessing the value of an asset. The idea is to update the value of an asset from its historic cost to its current value. For instance, a bank may have one of its properties revalued to reflect appreciation in real estate.

Perpetual Instruments
Primarily this consists of perpetual cumulative preference shares (PCPS). Like AT1 instruments, these securities have no maturity. A cumulative instrument is one where payments if missed, are accrued and paid when finances permit.

Dated Securities
Dated securities are those that have a maturity. Tier 2 Capital instruments are redeemable and may be cumulative or non-cumulative preference shares (RCPS or RNCPS). These instruments have a minimum tenor of 5 years.

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