Bond markets awaits borrowing calendar; yields to remain under pressure

Highlights:

•  The 10-year benchmark (6.35 per cent 2020 G-Sec) traded in range bound; closed at 7.85 per cent, up by 2 bps


• The average volume under Reverse Repo remained at Rs. 15,500 crores


• Inflationary pressures to continue; unwinding of accommodative measures by RBI to continue


• Non-food inflation also factoring into the overall inflation figures; will remain high in near term


• Borrowing calendar for the fiscal year 2010-11 to be announced on March 29, 2010; expected to be front-loaded


• Short-term yield curve to remain under pressure; G Sec spread for 5-1 years and 10-5 years at 220 bps and 39 bps respectively

Detailed View:

The policy rate action by RBI post market hours left traders dazzled on Monday and the yield on 10-year benchmark (6.35 per cent 2020 G-Sec) soared to 8.03 per cent, its 18-month peak before easing to 7.85 per cent, up by 2 bps over its last closing. This immediate reaction in the market was inevitable after RBI raised short term policy rates by 25 bps. Post action, the repo rate and reverse repo rate stand at 5 per cent and 3.5 per cent respectively. During the week, the yields on the benchmark G Sec remained in range bound and closed at 7.85 per cent, up by 2 bps. One basis-point is one-hundredth of a percentage point. Traders have been waiting eagerly for the weekly borrowing calendar to be announced on Mar 29 and expect that most of the borrowings are scheduled to be front loaded (60-70 per cent of total gross borrowings) in the first half of the fiscal year. The market will also keep a watch on the tenure of the bond issuances. The government has indicated that it would raise Rs. 4,57,000 crores from market in 2010-11, up by Rs. 6,000 from last year’s gross borrowing. Traders have been demanding short to mid term papers to be the major part of borrowing schedule in first half of the fiscal year following high inflation, unwinding of accommodative monetary policies by the central bank etc.

The RBI has been under high pressure on soaring inflation which is on continuous rise and has already touched near to 10 per cent. The inflation which used to be mainly due to food prices’ factors has moved to non-food prices’ factors too. Fuel inflation soared to 12.5 per cent for the week ended March 13. It might continue to remain high after the recent oil price hike by the government. Manufacturing inflation is also running at 4 per cent level and is expected to remain high as manufacturers pass the rising input costs to consumers.

The yields on 5-year 7.32% 2014 G-Sec rose by 6 bps to 7.24 per cent while 7.02% 2016 yield rose by 8 bps to 7.46 per cent.

On the liquidity front, the liquidity as measured by bids for reverse repo/repo under the Liquidity Adjustment Facility (LAF) remained comfortable with average bids for reverse repo amounting to Rs. 15,000 crores in the concluding week.

View and Recommendations

The yields at the shorter end of the curve will remain under pressure as the market would be witnessing a new round of borrowing next week onwards.
Liquid Fund and Ultra-short term debt funds (erstwhile called as Liquid-Plus Funds) should be the preferred choice for investors looking to invest their surpluses for a short duration (3-6 months) while for an investor having investment horizon of 9-12 months should invest in Income Funds. On return basis, LIC MF Income Plus Fund – Growth, IDFC Money Manager – Invest Plan – Growth and Kotak Floater – LT – Growth have been the front runners in Liquid Plus category in 6-months horizon. In Income Fund category, some of the actively managed funds are Fortis Flexi Debt Fund – Growth, Birla SunLife Dynamic Bond Fund – Retail – Growth and HSBC Flexi Debt Fund – Retail – Growth scoring 10.33 per cent, 8.27 per cent and 7.28 per cent respectively in 1-year category.
New FMPs have been flowing into the market on a continuous basis. Investors looking to lock-in their investments for a longer period (13-20 months) can consider this avenue as they will also get Double Indexation benefit (if invested before March 31, 2010) which will reduce the tax outflow on their FMP earnings.

RBI acts on Repo and Reverse Repo, a surprise for all

Indian Debt Markets are increasingly more on middle-of-the-road as traders awaited the borrowing calendar from RBI anxiously due on Mar 29, 2010. The inflation as measured by Wholesale Price Index (WPI) already reached to 9.89 per cent on month-on-month basis surpassing the RBI projection of 8.5 per cent. This has put policy makers to analyze all the monetary scenarios before announcing a roll back in accommodative measures. The Deputy Governor K C Chakraborty commented that the RBI might take measures anytime before the RBI policy meet on April 20 to tame the inflation which had shifted from Supply Side constraints to Non-food inflation constraints. An increase in non-food i.e. manufacturing inflation coupled with high IIP numbers (already in double digits nearing 16 per cent for two times in a row) prompted the RBI to announce a hike in policy rates, the first step seen in unwinding the stimulus packages and normalizing policy rates to tame the high inflation. The RBI hiked the Repo Rate and Reverse Repo Rate under the Liquidity Adjustment Facility (LAF) to 5 per cent and 3.5 per cent respectively with immediate effect, a hike of 25 bps over its last figures. Repo Rate is the rate at which the banks borrow money from RBI for meeting its short term liabilities and Reverse Repo Rate is the rate at which the banks put their surplus/money with RBI. This unexpected move may increase the sell offs by traders and yields may move northwards.

The inflationary pressures were of high concern as evident from RBI statement “Notwithstanding some moderation in recent weeks, food prices remain at elevated levels. In fact, consumer price inflation, as measured by various consumer price indices, has accentuated further. The acceleration in the prices of non-food manufactured goods and fuel items in recent months has been of particular concern.”  

The 10-year paper benchmark 6.35 % 2020 G Sec cooled off to 7.82 per cent, down by 18 bps week on week while the 5-year paper 7.32% 2014 saw yields slipping to 7.18 per cent, down by 13 bps. The cut-off price for the 91-Day T Bill was seen at Rs. 98.91 or at 4.42 per cent compared to previous cut off of 4.34 per cent. There was also a pressure seen on Corporate Bonds. On the shorter end of yield curve, the spread over G Sec in one-year category rose to 142 bps as on Mar 19, 2010, up by 16 bps. In 10-year category, the spread rose to 90 bps, up by 17 bps. The 10-year AAA bond traded at 8.88 per cent vis-à-vis 8.90 per cent as observed in last week.

Bond market nervous amid advance tax outflows

The Bond Markets traded northwards amid thin volumes. The yields sharpened northwards amid speculation that government will complete 60-70 per cent of total borrowing estimates in first half of the fiscal year 2010-11. Since the bond markets have already factored most of the economic developments related to bond markets, the traders awaited for the borrowing schedule program to be announced on March 29, 2010 by RBI before initiating their plan of actions. High inflationary pressures also dampened the mood among traders. The market is expecting an inflation to remain in the range of 9.5-10 per cent, much higher than the RBI estimate of 8.5 per cent. The banks’ credit growth has also shown encouraging numbers giving a fear among traders that the banks would be forced to subscribe to Government Securities and private firms would be crowded out. The banks’ non-food credit growth has reached 16.8 per cent level, higher from 11 per cent recorded in the month of Dec 2009.
The benchmark bond 10-year 6.35 % G Sec hardened to 8.01 per cent, a hike of 4 basis points (bps) over the last level of 7.97 per cent. One basis point is one-hundredth of a percentage. Index of Industrial Production (IIP) for January grew 16.7 per cent year on year basis, little below the market expectation of 17 per cent. The numbers prompted yields to ascend with 10-year benchmark G Sec to end at 8.01 per cent level. The other securities 7.02 % per cent 2016 saw yields rising to 7.68 per cent, up by 1 bps. The five year 7.32 % 2014 saw yields down by 4 bps to 7.30 per cent level and the 8.34 % 2027 yield dropped 2 bps at 8.38 per cent levels. Corporate bonds yields closed lower on weak to weak basis. The Five- and Ten-year corporate bond yields closed at 8.60 per cent and 8.90 per cent levels respectively. Moreover, the advance tax outflows may cramp the liquidity in the market.

Invest in ULIPs – A good Wealth Creator tool in long term

Out of the blue, the Indian insurance industry is the talk of Dalal Street as it has become a major contributor of investment in the equity market. Though premium collection slowed to some extent in early 2009, it has been gaining pace with the overall healthy market sentiment. Premiums collected under ULIPs are a major driver in boosting equity investment. Renewal premium of the industry in the ULIP category increased from Rs.26,638 crore to Rs.37,543 crore, an increase of 41 percent year-on-year. Insurance companies invested Rs.44,358 crore in equity between April and December 2009.

The practice of mis-selling ULIPs has largely been curbed after the insurance watchdog, the Insurance Regulatory and Development Authority (IRDA) introduced investor-friendly rulings, capping charges up to three percent and 2.25 percent for ULIPs with maturities of up to 10 years and those beyond 10 years, respectively. Moreover, the IRDA ruling on solvency ratio, corporate governance, public disclosures, payment made to intermediaries and allowing unit-linked health insurance plans, have greatly benefited the insurance industry.

How do ULIPs perform well in the long-term?

The major objective of ULIPs is to build wealth, steadily in the longterm as well as providing insurance cover, though investors must be clear that, investing in ULIPs is not to get high insurance cover. A fund manager in insurance companies can hold stocks for a longer period than his counterparts in other industries. Hence, churning in portfolio stocks, measured by Portfolio Turnover Ratio (PTR) is relatively less or negligible. Since churning involves costs, it has a major impact on a fund's performance. Higher the Portfolio Turnover Ratio, higher is the cost involved. Moreover, IRDA's cap on charges including a cap on Fund Management Charges (FMC) in case of ULIPs, bring more benefits to policyholders in the form of increased returns. A close look at the performance of other market related products vis-à-vis ULIPs throws up a startling fact. Other market related products lag ULIPs' returns by a large margin in the long run, which confirms that ULIPs are an ideal investment vehicle for wealth creation in the long term. On an average, the historical FMC in other market related products are lower. For mutual funds they come to about 2.1 percent whereas for ULIPs, the maximum FMC is capped at 1.35 percent.

For example, a periodic investment of Rs.1 lakh in a diversified equity linked fund (ELSS) for 15 years grows to Rs. 28.54 lakh at an assumed growth rate of 10 percent, giving a net yield of 7.69 percent

(Considering an average FMC of 2.1 percent). The same amount invested in ULIP for the same period may range from Rs.28.63 lakh to Rs.31.59 lakh at an assumed growth rate of 10 percent, giving a net yield ranging from 7.97 percent to 9.03 percent. The final value falls further if we consider other tax-saving instruments such as PPF, which gives a return of eight percent a year. An investment of Rs.1 lakh a year in PPF for 15 years grows to Rs.27.15 lakh.

So, clearly, ULIPs score over other products in terms of returns and additional benefit such as insurance cover. But it scores below PPF as an investment in ULIPs involves high risks. Returns on ULIPs rise due to lower FMC if the investment choice is a debt fund and assumed rate of return is 10 percent (in debt funds, the FMC is generally about 0.75-1 percent). The table shows the different returns.

However, the high entry costs and operational costs mar the performance of ULIPs on shorter maturity periods. Thus, we see that ULIPs appear to be the obvious choice for investments for creating considerable wealth in the long term.

SEBI’s ruling on Mark-to-Market may shun the attractiveness of Ultra-short term funds

Since the SEBI made mandatory for Liquid Fund managers to invest in papers with maturity of up to 91 days only, the Liquid Funds lost sheen among institutional investors due to reduced portfolio returns. This allowed the market participants to shift its focus to Ultra Short Term Funds (erstwhile called as Liquid-Plus Funds). Thanks to superior returns and tax benefits over Liquid Funds, Ultra Short term funds have found a favour among all class of investors.

However, the market watchdog SEBI still not very confident about the credit stability in the market issued another directive asking all mutual funds to value money market and debt securities with maturity over 91 days (or with maturity up to 182-days) on a mark-to-market basis with effect from July 01, 2010. The ruling will require all fund managers to factor in any movement in securities prices on a daily basis to calculate the Net Asset Value (NAV) of fund. The new valuation method may increase the volatility of Ultra Short Term Funds while Liquid Funds being shorter tenure funds will be less volatile. Currently securities having maturities over 182 days are already valued at daily weighted average (mark-to-market) method. The move will ensure that the Liquid Funds and Ultra Short Term Funds are undeniably liquid by asking them to be valued in a more transparent manner.

Ultra short term schemes which comprise 40 per cent of Indian Mutual Fund industry’s asset under management (AUM) of Rs. 7.59 lakh crore have been fetching returns in the range of 5-5.5 per cent having an edge over its sibling Liquid Funds fetching returns in the range of 4-4.25 per cent. The debt instruments held by Ultra Short Term Funds (or Liquid-Plus Funds) have a longer tenure i.e. the average maturity of these funds is comparatively higher than that of Liquid Funds. Long term papers (over 91 days) help fund managers to generate extra returns over short term papers (up to 91 days). Recently the RBI hiked the CRR by 75 basis points which increased the returns on Commercial Papers and Certificate of Deposits by around 100-150 basis points.

In the last few months, there have been continuous net outflows from Liquid Funds due to high dividend tax structure and restrictions to invest in papers having maturities up to 91 days only. Liquid Funds charge a dividend distribution tax (DDT) of 28 per cent unlike in Ultra Short Term Funds where the DDT is 14 per cent for individual and 22 per cent for corporate, thus, clearly giving a tax advantage of 8 per cent. Treasury Officials, CFOs etc prefer Liquid Funds and Ultra-Short Term Funds over Banks’ Fixed Deposits where interest income is charged at 33 per cent.

By issuing out the current directive, the regulator SEBI wants to make sure that the Oct 2008 Credit Crisis is not repeated where the RBI has to open a lending window for Mutual Funds for a limited period to ease out the crisis. However, the industry will continue to enjoy additional returns in Ultra Short Term Funds, though at a slightly higher risk as long as the tax-arbitrage is in existence over Liquid Funds and banks’ Fixed Deposits. The market will actively watch the upcoming Annual Budget on Feb 27, 2010 where the government may take away the tax arbitrage in Ultra Short Term Funds to make sure that Banks’ FDs are actively used for placing excessive unused funds, thus, bringing out a kind of stability in the credit market.