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Thematic Insights

30 Nov 2014

Duration Call
While we have been positive on duration for last few months and we have been riding largely
through tax-free bonds, which have seen drop in yield from 7.8% for AAA rated tax-free bonds
closer to 7%, we think there could be simultaneously further opportunity to make decent return by
participating in longer duration G-Sec market.
The chorus demanding rate cuts from the RBI has
grown stronger in the past couple of weeks with even
noted academicians and economists lending their
weight to the camp. Fresh indicators suggest that
economic activity continues to be sluggish. Add to that
what appears to be a sustained fall in inflation, and it
is plain to see the conventional case for a rate cut.
Simultaneously, investors over the past many years
have been used to thinking FMPs and money market
funds when they think fixed income. This has largely
worked since by definition in a rising rate environment
the lowest maturity product should do the best. Also,
owing to the same environment, there never was any
real fear of reinvestment risk. Thus, every year
maturing FMPs would always deliver a sufficiently
attractive reinvestment option which was almost
always as much or more than a short term or long
term bond fund could consistently deliver (no doubt,
lower expense ratio was also one more factor). Bond
funds, in turn, were used tactically. This period had
coincided with a substantial savings disequilibrium.
However, as the disequilibrium gets re-set to
normalcy, that investors have been used to may not
exist going ahead. If this is indeed a structural break in
inflation, it is imminently advisable that investors start
thinking of reinvestment risk as a real, tangible risk
that they need to hedge. Banks have already started
cutting deposit rates as an early sign of the
disequilibrium getting restored. Should the process
progress further, investors may no longer have the
assurance of predictability when their FMP allocations
come up for reinvestment.
As savings disequilibrium further improves and
conviction increases that the inflation regime has
indeed shifted, these rates may not be available for
future reinvestment. A portfolio that is convinced of

and is preparing for this new regime would focus on

the importance of earning the current level of interest
rates for longer periods of time.
Why bullish view on duration?
We believe following are major reasons for being
Bullish on Indian Government Bond Market Fall in CPI Inflation Trajectory (there is a
variety of reasons why we think that average
CPI inflation structurally will indeed be lower
in the next few years. Lower minimum
support price (MSP) settings for two years
now, deceleration in rural wage growth,
procurement and off-loading policies, and a
rethink in MNREGA structure and allocations
are some of the reasons supporting this
Global softening of commodity (specifically
crude) prices (Performance of gold and real
estate as asset classes has turned subdued
after a very strong run in recent years.
Hence, there is further disincentive to park
savings here and move towards financial
Adherence to discipline of Fiscal management
Structural Improvement in Liquidity Scenario
framework shows its commitment to micro
manage liquidity and keeping system liquidity
adequate. Thus overnight rate will be
anchored at Repo rate which will curb
volatility in short term rates and stabilize
rates at the shorter end of the curve).
implementation under way, land acquisition

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laws, FDI in defence and railways, etc. - So

far, the bulk of the reduction in deficit in past
two years has been taken up in form of
reduction in expenditure thereby impacting
growth to certain extent. We believe the
second stage of fiscal consolidation will be
achieved with an increase in Tax to GDP
rather than Expenditure to GDP . The
improvement in Tax to GDP will be driven by
a revival in overall economy, industrial output
growth leading to improvement in corporate
profitability and wider tax base. Overhauling
the subsidy regime with more targeted food
and fertilizer subsidies, diesel deregulation
policy and a formulation of the new urea
policy, will also help to reduce expenditure.
The new government will adhere to the fiscal
consolidation path & bring down Fiscal deficit
of 3% by FY2016-17.)
The new government is taking forward the
financial inclusion agenda via schemes like
the Jan Dhan Yojna which are effectively
working towards extending the net for
financial savings. While so far the success
here is limited, it is quite likely that such
schemes facilitate increase in financial savings
over the next few years.
A possible turn in the global commodity
super-cycle, incremental de-bottlenecking of
inputs supply, and potential pick up in
initiatives like Make In India all argue for a
well behaved CAD (savings investment
imbalance) even as growth picks up in the
years ahead.

Improving macro-indicators -

idle capacity across various industries. The same below

optimum capacity utilization across various industries,
shall keep inflation expectations lower for some time in
future. Gradual recovery in domestic economy shall
help corporate in utilizing their capacities in phased
manner and shall avoid situation of any major price
Tactical view
We expect the yield curve to shift lower with gradual
Bull Steepen over medium term horizon (say 9 to 12
months) 1. Improving liquidity conditions may help yields
lower ahead of rate cut :
a. Strong forex flows, due to portfolio and FDI
b. Lower inflation and thereby improvement in
financial savings and better economic growth
leading to better liquidity
c. RBIs liquidity management framework
(along with stable currency) to curb volatility
in short term rates and soften rates at the
shorter end of the curve
d. Banks have started reducing deposit rates
ahead of rate cuts
2. Now, rate cuts to happen soon, which will
shift yield curve lower parallel :
a. Better macro climate lower inflation, lower
fiscal deficit
b. Majority government to help decision making
c. If the above scenario looks plausible, then
investors should start looking at bond funds
(whether short or medium or long would
depend upon investment objectives and risk
appetite) as a means of hedging their future
reinvestment risks.
What should investors do

Our Economists (from RCML) view is gradual

improvement in economy from 5.3% in current
financial year (FY15) to 6.5% in next financial year
(FY16e). Yields have already peaked, improving fiscal
story accompanied by stable currency regime and
softening global commodity prices shall give
confidence to RBI to shift to accommodative stance
and robust FII flows will further support G-Sec yields
lower going forward. This is also possible because of

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We believe that series of rate cuts along-with the

abovementioned factors would make parallel shift
lower in yield curve and then as economic growth
picks up using up idle capacity there could be bull
steepening. If the above scenario looks plausible, then
investors should start looking at bond funds (whether
short or medium or long would depend upon
investment objectives and risk appetite) as a means of
hedging their future reinvestment risks. We believe
current high absolute levels of G-Secs are attractive
entry points for investors with capital gains focus &
longer time horizon of 18 - 36 months to build duration
in their portfolios.

Jignesh Shah

(This is based on inputs from various AMCs including Reliance AMC and IDFC AMC).

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