Tuesday, November 27, 2012


2008 crisis

With the collapse of Lehman Brothers, liquidity dried up, and so RBI cut repo rates severely – 9% to 3.5% in 6 months. Repo rates between Feb 2009 and May 2009 did not change, but the Government went in for some sort of quantitative easing and started spending and so without any changes in repo rates the yield went up to 6.5%. China went for investment stimulus and India went for consumption stimulus.- NEGRA, VIth Pay Commission, farmer loan waivers, excise duty cuts, etc. As there was no corresponding investment, there developed supply side constraints and the inflation pushed up. Current account deficit became a problem – India was borrowing from abroad to fund consumption.

3.50% repo rate bounded upto to 8.5% very fast. Exiting the 3 year interest rate hike cycles is not going to be easy. However going forward inflation will not lead to a rate hike by RBI, and ultimately there will be a rate fall. With a 5.5% growth rate,  RBI will have to do something to stimulate growth.

Current Situation:

RBI has been concentrating more on liquidity in the markets by reducing CRR by 25 bps in September, 2012.  There was an additional CRR cut by 25 bps in October, 2012.  Cash reserve ratio is the proportion of their deposits that they have to maintain in cash. They deposit this cash with the RBI. RBI uses CRR to drain excess liquidity or to release funds into the economy.

Growth is still very low. The June 2012 quarter GDP growth at 5.5% was slightly better than the March 2012 quarter growth. Growth was driven by Construction and services. The whole year’s growth is expected to be around 5-5.5%.

Exports declined 9.7% and dropped to $22 bn in August 2012 compared the normal range of $24-$25 bn per month. Trade deficit has therefore widened. The only positive was the slowing down of gold imports.

The tax revenues will be impacted due to the considerable slowdown in economic growth. There is also a grim outlook for budgeted receipts from disinvestment and telecom auctions. This would all adversely impact the fiscal deficit. The recent increase in diesel prices reduces the under recovery for diesel. The government has also confirmed that they will not be increasing their borrowings in the second half of this year.

Forex reserve at US$ 290.5 bn are at the same level of January 2008.  India’s import cover of 7-8 months is the lowest of the last decade. The average import cover for the last 10 years has been about 11.5 months. This is putting pressure on the rupee. To counter the rupee fall, RBI intervened in the forex market selling reserves of about $25 bn. However, the latest development on policy front has given some boost to the rupee. USD/INR will find it difficult to go below Rs. 53.

Credit growth has slowed down substantially. The biggest indicator of loan slowdown is the fact that both deposit and lending rates have been cut just at the start of the busy season on credit. This is a bullish trigger.

Persistent high inflation diminishes hopes of further rate cuts. Headline inflation in August 2012 came in at 7.55% versus 6.87% in July 2012. However, RBI has said that they may not actually wait of the inflation numbers to fall; so long as the momentum is in line with their expectations.

Debt Mutual Funds:

1.     Increased liquidity resulted in the short term rates falling sharply. Call market rates fell to below 8% and 1 year CD rates are currently at below 9%. Previously there was not much rate difference between the money market instruments and the longer term debt, but the rates at the shorter end of the interest rate curve has fallen substantially.

2.     Banks have front run the RBI by cutting interest rates. This is because of increased liquidity and banks are not looking at any credit growth. Interest rates are a based on demand and supply.

3.     There is has been a large demand for AAA rated paper and hence the interest rates have fallen by 25 bps and 40 bps. The 5 year AAA Corporate paper has fallen more than the 10 year paper.

4.     At some stage RBI is going to have to cut interest rates again to stimulate growth. However, without cutting interest rates the rates have been falling, because of increased liquidity and demand for paper to invest in.

5.     With the falling of short term interest rates, capital gains have already been earned in the short term debt funds. Thus short term rates are expected to remain within the range: 3 months CDs 8.4% to 8.65% and 1 year CDs 9.00% to 9.15%.

Hence going forward
1.     Hence need to look at debt funds of a longer duration currently. These could be more volatile, but with the inevitable cut of interest rates to stimulate growth as some stage, these funds would give 12%+ returns over the next year or so. Some longer term gilt allocation would be needed in the portfolio to give alpha.

2.    There is still a spread of about 1% between Corporate Bond funds and Government bonds. Hence these funds, with a longer duration, will be likely to give better returns – although the exit loads for these funds are longer – going upto 2.5 years.

3.    There is going to reinvestment risk, as the interest rates start falling. Hence at least 1/3rd of the debt portfolio would need to be in 3 year  FMPs. This is because after you earn on falling interest rates, by getting capital gains – going forward where would you invest. Would not really currently be looking at longer FMPs as the interest rates have fallen so sharply, and by that time we might be in the next interest rate cycle.

4.     If you do not currently have any short term debt funds, although there has already been a run in the short end of the interest rate curve, a small amount can be kept for stability in your debt portfolio. Further these too should give double digit returns as the fall is not totally over.

5.     Although there are accrual debt products – i.e. they match the yields (less expense ratio) with the modified duration – hence the capital gains on these products are minimal, but in a falling interest rates scenario, they should give better returns than FMPs. A small part could be in this.

6.      Finally, you need to be prepared for volatility in the debt market. There is a huge amount of FMP funds to mature in the near future. As the one year FMP rates have fallen to about 8%, these funds are going into debt funds, and hence even demand for debt paper is going to be there in the near future

Triggers for a Gilt market rally:
-         Interest rate cuts
-         Open Market Operations
-         Supply and Demand – with all the FMP paper maturing and banks demanding gilts for the year end.

Hence, start investing in debt mutual funds with a long modified duration (and with some allocation to gilts) and also in Corporate Debt funds.

Fixed Deposit vs Debt Mutual Fund

1.     With a fixed deposit, you get interest and at the end of the term you get your capital back.

2.     With a debt funds, the yield would be about the same as a fixed deposit, but over and above there can be a capital gain, when the interest rate falls. (the reverse can happen with rising interest rates). We are currently in the rare situation where RBI has clearly announced that there will not currently be any rising interest rates.

3.     The tax treatment also makes debt mutual funds more attractive. Interest on FDs attract income tax at your tax rate. Dividends are tax free and the fund pays Dividend Distribution Tax of 13%.

4.     For longer term debt funds held over one year, capital gain tax would be payable. If inflation remains high, the tax would be nil (indexing benefit), and could go up to a maximum of 10% (without any indexing benefit. This is more attractive than the highest tax rate of 30%.