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Debt Markets Work In Cycles Too

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.

Debt Note: Minimum Support Prices

Investment Strategy

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.




Market Outlook

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.

Fraught with Fraud

Last week PNB announced that it was the victim of fraud amounting to more than Rs. 11,000 Crores. While this was not foreseeable, the story has been unravelling. PNB has fallen victim to other cases of fraud in the past. In fact, it began disclosing fraudulent transactions in January that are associated with the current case. Jewellers and traders of precious metals are considered risky borrowers, yet a large part of its loan book is linked to these entities.

The bank wasn’t defrauded overnight. A deeper investigation indicates that the fraud has been ongoing for seven years. To understand what transpired, it is important to analyse the instruments and mechanisms involved. Lenders who want to borrow foreign currency (for import/ export) often find that credit facilities are cheaper abroad and may not be subject to currency fluctuations. To do this, they approach Indian banks who offer them a LoU (Letter of Undertaking) in exchange for collateral (security). Using these securities, the Indian bank then guarantees the foreign bank repayment of the loan it extends to the borrower.

PNB claims that no collateral was taken in exchange for these LoUs. Additionally, none of these transactions were recorded and there appears to be an unspoken understanding between some bank officials and the borrowers. This implies collusion on multiple levels and a systemic failure of the bank, its auditors, and the regulator.

Effectively, this has opened a Pandora’s box and leaves room for more discoveries of fraud. Ideally, this should result in greater scrutiny and tighter regulation. From a corrective standpoint, it is likely that there will be the integration of systems within banks so that all transactions are recorded. In particular, PNB may not be recapitalized.

Market Outlook

This incident leaves a stain on the Indian banking system. Demand for Indian credit will take a hit, which could further spike yields. In light of these circumstances, it is important to continue to manage risk in debt portfolios. Investments should be made into secure avenues that will be shielded from market volatility going forward. High-quality, low-duration, ultrashort-term funds would be ideally suited to the current market scenario.