“2-5 year debt maturity segment offers best risk-adjusted return”

The fund industry has perhaps over-complicated its fixed income products – so much so that few retail investors understand the offerings any longer, admits Rahul Goswami, CIO Fixed Income, ICICI Prudential AMC. In an interview with FundsIndia’s Research Desk, Rahul explains how the fund house seeks to minimize risk and generate returns in its debt products.

He also provides suggestions on what strategy would go well in the current interest rate scenario.

Excerpts:

There is little awareness about debt funds among retail investors. They also sound complicated to investors. What has ICICI Pru done to make these funds more retail friendly?

In the quest for getting the incremental institutional allocation in a competitive market, the fund industry has perhaps over-complicated its fixed income products – so much so that few retail investors understand the offerings any longer. These are times when simplicity is perhaps the biggest virtue – a lesson well absorbed by us.
We have introduced few products in the past few years that are positioned to the retail investors for example one of such products is ICICI Prudential Regular Savings Fund, a product in which we have capped the maximum subscription amount per investor at Rs. 15 Crs. The key feature is that it’s a 100% bond fund with almost 100% allocation to corporate debt – nil exposure to equity and minimal exposure to Government Securities.
The fund has seen a lot of interest from retail investors and has seen assets under management grow to Rs. 2836.10 Crs as on 31 March 2013 since December 2010 when it was launched. Apart from making available products that are clearly positioned for retail investors we have recently done investor awareness campaign to promote debt funds category to retail investors. This campaign has generated a lot of interest amongst the retail investors.

Debt funds are perceived to be risky when compared with traditional debt products? How does your fixed income strategy allay this fear?

The key guiding principle to our investment philosophy is to maximize the risk- adjusted returns for our investors in the respective asset classes, and create wealth for them over the long-term.

Based on our overall fund investment philosophy, the investment objective derived is to optimize risk adjusted returns. This is achieved by investing in high credit fixed income securities, managing interest rate risk and minimizing liquidity risk.
The group seeks to achieve Safety, Liquidity and Returns (SLR) in that order of priority while managing a variety of schemes. Aligned to this the first priority in buying corporate bonds is safely, liquidity followed by returns.
We continue to hold majority of our portfolios in liquid segment of the corporate bond market thereby mitigating safety/ liquidity driven risk on the portfolio. We look at capitalizing on a credit opportunity when we are opportunistically able to find a good risk reward ratio. On a stand-alone basis we are very selective as far as credit opportunity is considered given that we manage money in fiduciary capacity.

What is your take on the interest front and how do you see it panning out going forward?

The 10-year benchmark Government bond yield have moved to 7.35% (data as on 21 May 2013) which is a sharp down move of about 38 basis points from April 2013 end closing of 7.73%. Commodity prices have continued to show softness after a steep fall like in case of Gold or Oil.
Also in the Asian region, central banks have cut rates based on softening commodity prices, lower growth numbers and expectations of lower inflation.

Locally, with lower inflation number and expectation of a lower GDP for FY 2013, market is expecting RBI to continue with rate cut in June policy as well. The bond market is pricing in another 50 basis-point rate cut by RBI over the next 2-3 policy announcements.
There is potential for bond markets to rally further, and this is based on the expectation of RBI continuing on the path of monetary easing based on softening in inflation and growth slowing. Also we believe that with the recent steps taken by the Govt. of India and the RBI on curbing gold demand and imports, the current account deficit should trend downwards giving RBI more flexibility and space as far as monetary easing is concerned. We believe there is space of about 75 basis point of cut in the benchmark repo rate through the current FY-14.

How do you expect bond yields to move as interest rates move southward?

In response to your question, it is important to understand the current shape of the yield curve and the significance of its interpretation in identifying opportunities for investors.
The flatness in the yield curve theoretically is an indication to what extent the market is bullish. When the longer end of the curve comes down aggressively towards the shorter end of the curve, it is called bull flattening.
Bull flattening is possible or justifiable if the collective wisdom of the market believes that the central bank is behind the curve and so there is nothing that the shorter end of the curve will be able to do but the longer end of the curve will bring about a compression in the short term and the long term bond yields.

If investors believe that the central bank will be behind the curve, then it is better for them to buy the longer end and let the yields come down. Later when the central bank action happens, the roll down will also benefit them.

So this is the reason we are seeing the 30-year bond trading at 7.5% while we have the mix of old and new ten-year bonds trading at 7.25%. 3 month T-bills and 1 year T-bills are also trading at 7.25%. Once the market believes the central bank is now in line with the rate cutting cycle, the curve will start steepening and you will see yields on 2-year -5 year bonds coming down much faster than the yields on the longer tenure bonds.

What influence will inflation have on bond yields?

In 2008-09 the fiscal and monetary policies led to inflation. At the end of 2009, one year T-Bill was closer to 3.5% and ten year bond was closer to 7%. Today one year T-Bill yields 7.25% and ten year bonds continues to trade at 7.25%. Going forward for the next 3-5 years, my view is that the government should have fiscal policies such that inflation will remain low. Inflation in the next say 3 to 5 years should average around 5%-6%.

The average inflation in the last 10 years has been around 6%- 6.5% and it should be around 5%-5.5% in the next 10 years. So I think on an average basis, ten year bonds can sustain below 7.35%- 7.40% for a long time. And, as long as inflation is in the 5-6% range, you can’t expect overnight rates to fall much below 6%.

If the yield curve is likely to move from a flat 7.25% across all tenors to something like 6%for overnight instruments; rising to 7.25% for 10 year maturities, it makes sense to focus on the 2-year to 5-year segment, which will really form the belly of the curve, when it steepens – because this is the segment that could see the sharpest relative reduction in yields, going forward.

What category of debt funds offer opportunity when interest rates are falling?

Typically long-term debt funds emerge as an appropriate investment tool as it generates superior returns in a falling interest rate environment. Long-term debt funds include income funds (which invest a majority of their corpus in Govt. Securities as well as long tenure debt instruments issued by corporates) and gilt funds (which invest in bonds issued by the central and state governments).
The value of the underlying debt instruments in their portfolio fluctuates on a daily basis (known as market risk) due to factors such as interest rate movement and the liquidity situation. The price of debt instruments and interest rates (yields) move in opposite directions, i.e. price of the bond rises when interest rates fall and vice versa.

A study conducted by CRISIL Research across 2000-04, 2008 and post April 2012 – cycles with a falling interest rates – have shown that returns from gilt funds were the highest across debt fund categories at 16.15%, 60.12% and 11.26%, followed by income funds at 11.89%, 34.61% and 10.66%, respectively.

The returns were higher than that offered by bank fixed deposit rates during the same periods. Investors should, however, be mindful of higher volatility in gilt funds as compared to other debt funds as these are prone to interest rate fluctuations. Income funds on the other hand tend to provide more stable returns in the long term and also have the leeway of taking exposure to gilts as per the interest rate scenario.

Income funds also provide investors exposure to higher rated corporate securities that trade at higher yields compared to gilt prices providing cushion to the additional risk.

We believe that current market conditions are likely to benefit investments in duration funds like Income, Gilt funds as we expect bond markets to rally further. Most of the recent gains have come in these duration funds.
The shorter and the medium-term maturity funds have also done reasonable well. Structurally we see rates moving down at least through this current financial year on account of softening commodity prices and inflation. The Reserve Bank of India (RBI) will have more flexibility and space as far as monetary easing is concerned.

Going forward, we expect the Central Bank to do more open market operations (OMO) and buy bonds in the shorter-end of the bucket rather than infusing liquidity by buying 10-12 year maturity bonds.
With expectations of RBI continuing with monetary easing by cutting rates in future and also improving liquidity by conducting OMOs at the shorter end of the curve, makes shorter and medium end of the curve very rich and reasonably well rewarding.

What is your advice to investors in the Indian debt markets at this juncture?

Retail investors may benefit out of investing in duration funds like Income and Gilt funds and also Dynamic bond funds. Our advice is that the investor should talk to their financial advisor, understand his risk profile and requirements and accordingly take appropriate risks that suit his investor profile. On a risk adjusted return basis we see that it is best to invest in the 2-5 year maturity segment of the yield curve.

This is ideal for best risk-adjusted return and also to mitigate the reinvestment risk arising out of falling interest rate scenario. Products like ICICI Prudential Regular Savings Fund and ICICI Prudential Short Term Fund focus on this maturity segment.