India’s stable fixed Income architecture and yield landscape
Debt Fund
Background – defining the architecture
Small events at the time they are introduced are almost never noticed or get enough attention. Two such seminal events happened in India a few years ago. The first being the shift by the Central Bank (CB) in 2013, to using Consumer Price Index (CPI) as the main inflation gauge to guide its policy setting initiatives.
The second was amending the RBI Act in 2016, to introduce a legal basis for inflation targeting agenda. Introduced in 2016, RBI has a mandate until March 2021, to target CPI at 4% +/- 2%.
Post these measures, CPI which was at 10% in 2012, slumped to 4.9% by 2015 and has since mostly stayed under 5%. Lower inflation has helped RBI lower rates over time. From 7.50% in 2013, repo rates are now at 4.00%, a decline of 350 bps.
As the reconstituted MPC met in October, the transition marked the first change within the new institutional framework. In the backdrop of success achieved in taming inflation, we await to see if the MPC mandate gets altered either on inflation or introducing growth as an equal priority in 2021.
Falling yield landscape
Defining a sound fixed income architecture has borne benefits, allowing RBI to align rates with falling inflation. Key administered products (EPF,PPF, Post Office, NSC) and bank deposit rates have all been moved southwards in the last few years.
1 year Bank FD rates which fetched 9% on average in 2013, now earn exactly half at 4.50%. PPF which earned 8.80% in 2013 is down to 7%. Savings bank rates fetch 2.5% for upto 30 days, being lower than CPI.
G secs have had a steady downward decline too. From almost 8.15% levels in October 2018, they are now down 225 bps in exactly 2 years to under 6% in October 2020.
Presently, reverse repo (which is the operative rate) is at a historical low of 3.35%. 10 year G secs however are close to 6%, at almost a 260 bps spread, which is a historical high and makes long bonds highly attractive. However, long bonds come with volatility given rate movements.
Given the extremely weak growth environment, RBI’s push on liquidity and accommodative stance and likelihood of inflation subsiding in the medium term, such level of spreads in our view are very attractive.
Hence investors are better off positioning in the mid segment products – which buy the 3-7 year bonds - which enjoy almost a 200-250 bps spread over reverse repo rates.
On a post-tax basis, Short and medium duration funds have done exceedingly well. Corporate bond and Banking PSU funds have delivered over 7.75% and 8.5%, annualized respectively in the last 3 years, beating both bank FD / administered rates. On a post tax basis, these funds have also beaten AAA tax free bonds by 100-125 bps.
Credit funds have had a mixed record. Excluding outliers this category has delivered under 4% in the last 3 years, far below the short term products.
Positive yield outlook
Globally rates in most developed markets are clearly in a long phase of near zero ranges. The phrase of “lower for longer” is reiterated at almost every Fed meeting to give comfort to markets and investors. The move underpinning these actions is clearly uncertainty on growth and unemployment levels returning to pre-covid levels. For perspective, 10 year Govt bond yields in Japan, Germany, UK and US are at 3 bps, -61 bps, 19 bps and 82 bps, respectively.
Locally, the new MPC has stated “growth” to be its priority and willing to overlook “ high inflation” for the time being, and willing to keep rates low to promote growth as a priority.
Trailing returns in fixed income products have enjoyed a tailwind from steep rate cuts of 115 bp in the last 6 months. Although there is a likelihood that we have witnessed the best part of the rate cuts, yields can move lower even without rate cuts given the existing spreads over the reverse repo and repo rates. Another rate cut cannot be ruled out and could end up being back-ended in this cycle, if growth fails to lift off in the next 6 months.
On balance, the short and medium term products certainly offer a great choice in the current situation, with the odds stacked in their favour, as yields face a downward bias. Investors should hence remain adequately positioned to benefit from this move.
Short term category has done well vis-à-vis long duration and credit by way of long term stability and predictability of returns. Corporate bond funds and Banking & PSU funds should hence form a core part of a retail investors fixed income asset allocation.