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WF: Some fund houses are looking beyond RBI's last "hawkish" posture and are betting on a significant reduction in interest rates in the coming 12-18 months due to sluggish credit offtake, absence of investment pick up and benign inflation outlook. Do you share this assessment?
Sivakumar: RBI's stance in the last couple of policy meets has some merit - the current soft inflation patch is due to a sharp fall in food prices post-demonetisation, and once this is behind us, we might see inflation inch back up. Upside risks to inflation thanks to GST and implementation of the Pay Commission award are also on RBI's radar. The global outlook for inflation and growth has also ticked higher and we are no longer facing the deflationary scenario of 2015. On the downside, bank credit growth and potential disruption to growth in the wake of GST could keep inflation low. On balance RBI's stance appears fair. The markets are confused by RBI because its stance has shifted from accommodative to neutral in the last few months despite no new evidence of upside risk to inflation. This suggests some policy uncertainty risks that the markets will have to price going forward. That is likely to keep long bond yields elevated compared to short end rates.
WF: The optimism on corporate earnings growth which is driving the stock market upwards should normally imply growing appetite for credit and therefore tighter conditions in the money and fixed income markets. How can one explain concurrent bullishness in both equity earnings as well as in bond yields falling?
Sivakumar: We have seen two factors driving corporate earnings in the last couple of years. First, margins have expanded as commodity prices remain much lower than the levels seen three years ago. In more recent quarters there is also some evidence of demand recovery which has boosted top line numbers. The combination of these factors has allowed earnings to rise - and importantly allowed many highly leveraged companies to reduce debt. In addition many companies have found it cheaper to borrow in the debt and money markets rather than banks which has also resulted in lower reported bank credit growth. We believe that the overall flow of funds to the corporate sector - across bank and non-bank channels - are sufficient to fund the needs at current growth rates. For economic growth to have a larger impact on credit growth and liquidity we need to see a capex cycle recovery.
In the wake of demonetisation, we saw bond yields drop and equity indices fall. Both indicated some fear of growth slowdown. Several months on growth appears to be back to near normal levels. Consequently bond yields have risen and equity markets have rebounded. The only segment of debt markets which continue to trade at low yields is the money market where excess liquidity has capped rates.
WF: From the current 6.65% levels, where do you see the benchmark 10 yr G-Sec yield going over the next 12 months?
Sivakumar: In the last few months inflation has remained below RBI's target of 4%. However this has been led by a sharp disinflation of pulses, fruits and vegetables. Once this normalises, we should expect inflation to retrace to the 4.5-5% band through the course of the year. Given a normal real rate, it appears that the market is fairly valued. To the extent that there is some upside risk to inflation and because of RBI policy uncertainty, we expect that the market may have a bias to rising yields in the next several months.
A second factor driving government bond yields higher is the large pace of new issuance. Gross issuance by the centre and states is likely to cross ?11 trillion. The demand for G-Secs is likely to remain weak especially if banks, who are the largest buyers of government bonds, see weak deposit growth.
WF: How have you been calibrating your duration strategies in recent months in response/anticipation of evolving market dynamics?
Sivakumar: We believe that the long end of the curve is about fairly valued with some upside risk to yields - that is downside risk to prices. As such we expect to maintain a lower duration stance than we have been maintaining over the past three years. The yield curve offers great steepness up to the short segment, say up to 5 years to maturity. Post that it is relatively flat. Thus short bonds offer a yield pick up relative to money market, and at the same time are not as exposed to the volatility of the long end. Our preferred part of the curve is between 1 and 5 years.
WF: What is your outlook on corporate credit in this environment? Does it now make sense to venture down the rating curve in search for value?
Sivakumar: The macro outlook for credit has improved over the past couple of years driven by margin expansion and a pickup in economic growth. This has been reflected in an improvement in credit ratios. The number of upgrades has been outpacing the number of downgrades for the past several quarters. The highly leveraged/indebted companies are still getting downgraded: thus the total value of debt downgraded still exceeds upgrades. This suggests that while the overall credit environment is better, we have to be selective in choosing credits in the portfolio.
While investing in credits it is also important to diversify. While the regulatory limits are 10% for a single issuer, we prefer to limit ourselves to under 5% for AA issuers and under 3% for A rated issuers. We are also diversified across sectors and corporate groups. We also try to avoid marrying credit to duration - that is we try to stay away from long term credits. The secondary market for lower rated bonds is practically non-existent. Thus we prefer to own short-term non-AAA debt.
WF: How are you positioning your accrual funds now? Are there any significant changes you have made recently in either fund strategy or portfolio composition?
Sivakumar: As the macro environment points to better credit performance, we have been looking to add to credits in our short to medium term portfolios. The past year has also seen better spreads for lower rated bonds relative to AAA bonds (compared to late 2014 to mid 2015). Thus we have a scenario where corporate profitability and credit performance has improved while spreads are more favourable - a combination we like. Within our credit exposures we like to maintain a highly diversified, short term portfolio.
WF: Where do you see the best opportunities today in the fixed income space?
Sivakumar: We are at an interesting place in terms of yields. Money market yields have collapsed on the back of easy liquidity, while at the same time long bond prices have slumped in the wake of RBI hawkishness. In this environment, we prefer short term bonds which offer higher yields relative to money markets, while not being affected by the long bond volatility. We also believe that the improvement in the underlying economic growth will translate into better performance for credits relative to government bonds. Thus we expect to maintain a higher allocation to short corporate bonds.
Statutory Details: Axis Mutual Fund has been established as a Trust under the Indian Trusts Act, 1882, sponsored by Axis Bank Ltd. (liability restricted to Rs. 1 Lakh). Trustee: Axis Mutual Fund Trustee Ltd. Investment Manager: Axis Asset Management Co. Ltd. (the AMC) Risk Factors: Axis Bank Limited is not liable or responsible for any loss or shortfall resulting from the operation of the scheme.
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