Continue investing in duration..
Yields have fallen, yet long way to go
Lower rates cycle has just begun.

Our View – Summary

• Risk / Reward favors a long position

  1. Tracing Global Central Banks’ Action: RBI has followed the Fed. Fed concerned about risks of banking system crisis, may lead Fed pausing faster than anticipated. We expect a Fed cut, whenever, to be precursor to RBI cut.
  2. Favorable Demand-Supply: Despite market concerns, bond Demand is fairly matched with Supply. States have Rs. 2.5 lac cr of cash. SDL issuances may continue to be muted in Fy24 – as in FY23.
  3. RBI OMOs: In FY24, RBI will finally purchase govt bonds, after a gap of more than 1-year.
  4. Lag effect of rate hikes: The rate hikes have few quarter lag. The impact in economy will start showing now. Not just lower inflation, but economic slowdown and unknown event risks are heightened across the globe. RBI in its policy acknowledged the same.

• Risks to our view

  1. Global Inflation: High inflation globally can lead to Fed turning hawkish. Domestically weather-related disruptions can pose a risk in terms of high food inflation – though this may be short-lived.
  2. Geo-politics: Escalation between China / Taiwan. This would lead to supply chain disruptions (inflationary) and risk-off in capital markets (rupee depreciation).
  3. Brent crude prices: After OPEC supply cut, brent prices have risen. There are risks that it may move even higher – posing twin challenge to inflation and rupee.

• Risk/Reward to take duration risks

  For long duration investment: We advise to maintain duration –as risks to yields spiking up are few – and tail events risk rally.
  For money markets investment: Even though the yields have rallied, we believe staying in the longer end of the money markets curve is more beneficial due to prospects of locking rates for longer tenor.

RBI: Reserve Bank of India; G-Sec: Government Securities; OMO: Open Market Operation; SDL: State Development Loans; BOP: Balance of Payment

Let’s revisit our rates call trajectory

RBI surprised with a PAUSE

• Rate Action

  Unanimously voted to keep key policy rates unchanged at 6.5%

• Stance

  5 of 6 members voted for remain focused on withdrawal of accommodation

• Inflation

  Revised lower by 10bps to 5.2% for FY24

  • ✓ Annual average crude oil assumed at $85 vs $95 the previous policy
  • ✓ Record rabi foodgrains and expectation of normal monsoon provides comfort
  • X Global inflation uncertain and impact of recent unseasonal rains to be watched

• Growth

  GDP forecast revised higher by 10bps to 6.5% for FY24

  • ✓ Good rabi crop to support rural demand
  • ✓ PMI (Purchasing Managers’ Index) remains strong
  • X Slowing global trade and uncertain global financial conditions remain a concern

Term premia at its peak!

• Closer to peak rates the term premia reduces considerably

  
  
  • In 2014, the term premia reduced – with long term yields below repo before rate cuts
  • In 2018, term premia crashed at peak rates
  • Both these instances led to rally in duration yields

• Term premia reduces during the period of pause

Takeaway:
Term Premia has been low historically in years of high policy rates.

OIS – Overnight Indexed Swap Source – Bloomberg; Data as on 6/4/2023

Supply should not be a concern

Takeaway:
SDL supply much lower than calendar so far with high cash balances, supply may remain muted in FY24

US bank lending slumps

• Highest fortnightly contraction since Federal Reserve data available (1973)

  • Commercial bank lending declined $105 billion for fortnight ended Mar 29, 2023
  • Broad-based decline across the sectors

Takeaway:
Banking system crisis has had a larger impact on credit growth vis-à-vis Fed rate action

Source – Bloomberg; Data as on 12/4/2023

Our Framework

Takeaway:
Most Parameters point to lower yields. The risk/reward favors a long position in bonds.

Source – Internal CAD – Current Account Deficit; BoP – Balance of Payment; SLR – Statutory Liquidity Ratio; SDL – State Development Loans; RBI: Reserve Bank of India; G-Sec: Government Securities; CPI: Consumer Price Index; MSP: Minimum Support Price; OMO: Open Market Operation; FPI: Foreign Portfolio Investment; MPC: Monetary Policy Committee

Inflation concerns abated for now

Takeaway:
CPI within RBIs tolerance band, may not be the sole moving factor.

Source – RBI, CSO, Bloomberg CPI: Consumer Price Inflation; RBI: Reserve Bank of India; IGB: India Government Bond

Will global slowdown test domestic growth?

Takeaway:
Domestic growth seems resilient despite global slowdown fears

Source – Bloomberg GDP: Gross Domestic Product; PMI: Purchasing Managers’ Index; GST: Goods and Service Tax; IGB: India Government Bond; Mfg: Manufacturing

What drives pauses: Series of hygiene factors

Takeaway:
RBI delivered a pause in Apr 23 MPC

Source – RBI, Bloomberg RBI: Reserve Bank of India; IMF: International Monetary Fund; US FED: US Federal Reserve; BoP – Balance of Payment

Gsec market still driven by lumpy institutions

Takeaway:
Increase in supply impacts the discretionary buying. Banks excess holding, passive buyers have been absorbing the supply

Source – DBIE LCR – Liquidity Coverage Ratio; SDL – State Development Loans; PF – Provident Funds; PD – Primary Dealerships; MF – Mutual Funds; FPI – Foreign Portfolio Investors; FI – Financial Institutions; RBI: Reserve Bank of India; G-Sec: Government Securities; SDL: State Development Loans

How much is the excess supply

• Excess supply can be matched by

  • ✓ G-sec supply higher only by 7% over FY23, however demand is expected to rise much more
  • ✓ Continuing strong demand from Banks and long end investors like EPFO, Insurance and PFs
  • ✓ Limited room for OMO purchases by RBI as minimal G-sec maturities this year

Takeaway:
Estimated excess supply of INR 1.67 tn not very significant, considering any increase in SLR holdings by banks can substantially reduce the gap

Source – Internal G-Sec: Government Securities; OMO: Open Market Operation; RBI: Reserve Bank of India; FPI: Foreign Portfolio Investment; NPS: National Pension System; MF: Mutual Fund; SDL: State Development Loans; SLR: Statutory Liquidity Ratio; PF: Provident Fund; EPFO: Employees’ Provident Fund Organisation

Demand – In neutral zone for FY24

Takeaway:
Demand – Supply is broadly balanced, but new buyers can provide fillip

Source – Bloomberg, DBIE, Internal OMO – Open Market Operations, SLR – Statutory Liquidity Ratio; G-Sec – Government Securities; RBI: Reserve Bank of India; FRA: Forward Rate Agreement; TRS: Total Return Swap

RBI OMO: Coming in FY24

• System Liquidity sharply reduced over the last one year

  • Increase in Currency in Circulation (CIC) has drained out INR 2.5 tn in the past year. Currency in circulation is cyclical increasing during Jan-May
  • CRR hiked by 50bps in the May’22, which drained out INR 87k crore of liquidity instantaneously
  • RBI’s interventions in the Foreign exchange market
  • TLTRO (Targeted Long Term Repo Operations) Maturities of INR 61k crore will further tighten the liquidity in April 23

Takeaway:
RBI to conduct OMO Purchases when liquidity tightens. Expected to be in FY24

RBI actions followed FOMC – expect the same going ahead

• RBI has echoed FOMC decisions, albeit more moderately

  • RBI started hiking after Fed
  • RBI rate hikes 25bp lower than Fed – in every policy

Takeaway:
RBI hikes following hikes by the Fed

Are Indian yields de-coupled from global markets?

Takeaway:
India bond yields more driven by domestic factors.

Source – Bloomberg, Internal Fed: federal Reserve; CPI: Consumer Price Inflation; RBI: Reserve Bank of India; IGB: India Government Bond

CD Supply to remain elevated, yet pace of supply to reduce

• Divergence between credit and deposit growth continues
• Increased Certificates of Deposit (CD) issuances by banks
• Extent of maturities this quarter lower vis-à-vis last quarter, though still high

Our View – Summary

• Risk / Reward favors a long position

  1. Tracing Global Central Banks’ Action: RBI has followed the Fed. Fed concerned about risks of banking system crisis, may lead Fed pausing faster than anticipated. We expect a Fed cut, whenever, to be precursor to RBI cut.
  2. Favorable Demand-Supply: Despite market concerns, bond Demand is fairly matched with Supply. States have Rs. 2.5 lac cr of cash. SDL issuances may continue to be muted in Fy24 – as in FY23.
  3. RBI OMOs: In FY24, RBI will finally purchase govt bonds, after a gap of more than 1-year.
  4. Lag effect of rate hikes: The rate hikes have few quarter lag. The impact in economy will start showing now. Not just lower inflation, but economic slowdown and unknown event risks are heightened across the globe. RBI in its policy acknowledged the same.

• Risks to our view

  1. Global Inflation: High inflation globally can lead to Fed turning hawkish. Domestically weather-related disruptions can pose a risk in terms of high food inflation – though this may be short-lived.
  2. Geo-politics: Escalation between China / Taiwan. This would lead to supply chain disruptions (inflationary) and risk-off in capital markets (rupee depreciation).
  3. Brent crude prices: After OPEC supply cut, brent prices have risen. There are risks that it may move even higher – posing twin challenge to inflation and rupee.

• Risk/Reward to take duration risks

  For long duration investment: We advise to maintain duration –as risks to yields spiking up are few – and tail events risk rally.
  For money markets investment: Even though the yields have rallied, we believe staying in the longer end of the money markets curve is more beneficial due to prospects of locking rates for longer tenor.

RBI: Reserve Bank of India; G-Sec: Government Securities; OMO: Open Market Operation; SDL: State Development Loans; BOP: Balance of Payment

DSP FI Framework checklist : What is our view on yields movement?

DSP Duration decision: How much of yield movement is priced in?

The chart shows how much expected yield fall/rise is already priced in the current curve.

Large gap between the current yield and forward yield shows that yield change is priced in – and thus yield change will not give capital gain/loss.

Similarly small gap means that the market is not pricing change in yields.

• Market expects yields to remain unchanged

  • The future rate curve is close to current yield curve.
  • Means, that market is not pricing yield fall

• Where to invest?

  • We advise investors to invest in longer end of their risk boundaries.

DSP Portfolio Creation: Multi-step process

DSP Fixed Income Funds follow a defined methodology for fund portfolio construction

• We apply market risk filter which can help the Fund Managers not to take extreme risks. Thus, Value at Risk is limited by ensuring the positions are balanced.

Investment approach / framework/ strategy mentioned herein is currently followed & same may change in future depending on market conditions & other factors.

DSP Credit Investment Process – Better Safe, than Sorry!

DSP Asset Allocation: Corporate bonds vs. Sovereign Bonds

Takeaway:
Corporate bond spreads near their long term average, spread curve may flatten.

Source – Bloomberg, CCIL

Key Risks associated with investing in Fixed Income Schemes

Interest Rate Risk - When interest rates rise, bond prices fall, meaning the bonds you hold lose value. Interest rate movements are the major cause of price volatility in bond markets.

Credit risk - If you invest in corporate bonds, you take on credit risk in addition to interest rate risk. Credit risk is the possibility that an issuer could default on its debt obligation. If this happens, the investor may not receive the full value of their principal investment.

Market Liquidity risk - Liquidity risk is the chance that an investor might want to sell a fixed income asset, but they’re unable to find a buyer.

Re-investment Risk - If the bonds are callable, the bond issuer reserves the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment risk especially in a falling interest rate scenario.

Rating Migration Risk - If the credit rating agencies lower their ratings on a bond, the price of those bonds will fall.

Other Risks
Risk associated with

• floating rate securities
• derivatives
• transaction in units through stock exchange Mechanism
• investments in Securitized Assets
• Overseas Investments
• Real Estate Investment Trust (REIT) and Infrastructure Investment Trust (InvIT)
• investments in repo of corporate debt securities
• Imperfect Hedging using Interest Rate Futures
• investments in Perpetual Debt Instrument (PDI)