REASONS FOR BENCHMARK GOING UP

Kindly refer to my various blog notes on why invest in long term G-Sec schemes. I have spoken about the same since the eve of the July Credit Policy. Also, as was foreseen by most market participants and reiterated by RBI, that containing inflation is going to be a bigger priority than pushing for growth, & hence it was a foregone conclusion that there will further rate hikes in between policy dates and on policy dates as well.

Keeping this in mind I had suggested a strategy of investing in G-Secs every Friday since the date of Policy and continuing investing for the next 3-4 months. This strategy was to

a)       Mitigate risk of yield spikes which are imminent

b)       Create an average at every rise in yields & c) wait for one correction based on various fundamental & technical reasons mentioned in my various notes & exiting thereafter.

Since the Policy date, 10 year benchmark yields have gone up steadily from 7.70% (on policy date  to currently at 8.05% (after touching a high of 8.08% yesterday i.e. yields have gone up almost 30 bps from the policy date & likely go up further on future rate hike dates). As mentioned by me, one can not time the entry at ultimate peak nor time exits at ultimate bottom; strategy of investing on weekly basis will help in creating an average without resorting to timing the markets.

Main reason for the 10 year benchmark yields moving up so sharply over the last few days is that market participants have started offloading this G-Sec ahead of the time when it will become illiquid in a few months time when new benchmark will be announced & to make it worse there is another Rs.15000 Crs of issuance of this bond which is yet to come. Question is who is going to buy this security when everyone is on a selling spree of 2020 paper.

Over the past few months when yield differential between 7.80% 2020 & 8.13% 2022 papers was almost 20-25 bps (i.e. 2022 on yield basis was quoting 20-25 bps higher than 2020- which is how it should be priced) ;  is now currently in reverse ratio wherein 2020 is quoting 8.05% v/s 8% yield on 2022 paper. All this is due to more technical factors and demand/supply issues & not connected to fundamentals of the market. Since there is no clarity from RBI on whether they will still support liquidity of 2020 for a few more months, market participants are getting jittery and are in oversold position. In fact most of the MF schemes should be out of this paper & sitting light. They are more invested in 5 year & 12 year G-Sec papers.

This is evident from the analysis I have done of the strategy recommended by me of investing in G-Sec (since July policy) on weekly basis. Most of the schemes till August 24 were marginally positive or marginally negative (inspite of the fact that 10 year benchmark as mentioned above has gone up by more than 30 bps since then to now):

I had selected 4 schemes wherein an investor would have invested Rs.1cr on weekly basis on Fridays. I have also mentioned the 10 year benchmark yields on those dates and the current 10 year benchmark as on August 25’2010:

S. No.	Date	Total value	Current Date	Period	10 yr G-Sec
1	27-Jul-10	1,00,00,000	25-Aug-10	28	7.72
2	30-Jul-10	1,00,00,000	25-Aug-10	25	7.80
3	06-Aug-10	1,00,00,000	25-Aug-10	18	7.83
4	13-Aug-10	1,00,00,000	25-Aug-10	11	7.82
5	20-Aug-10	1,00,00,000	25-Aug-10	4	7.98
		5,00,00,000	8.07		7.83

As you can see from above table, average of 10 year benchmark is at 7.83% whereas yield of 10 year benchmark as on August 25’2010 was 8.07%. Following is the outcome of our above investment strategy with 4 G-Sec Schemes with current value of Rs.5 Cr investment (i.e. Rs.1 Cr invested every week since past 5 weeks):

1	DSP BlackRock G-Sec	5,00,00,000	4,98,62,238	-1,37,762	-0.27
2	ICICI Prudential GFIP	5,00,00,000	5,02,13,010	2,13,010	0.43
3	Kotak Gilt – Investment Regular Plan	5,00,00,000	4,96,65,450	-3,34,550	-0.67
4	Birla Sun Life G-Sec Fund – LT	5,00,00,000	5,01,27,420	1,27,420	0.25

As can be seen from above, inspite of yield spikes of more than 35 bps and average of our strategy investments yield at 7.83% v/s current benchmark yield at 8.07%; this strategy has posted marginal positive/marginal negative or no returns so far. By creating average going forward at maybe higher yields, with other fundamental factors like lowering commodity prices, lowering inflation, higher revenue and other receipts by the Govt etc affecting the markets positively; the said strategy should pay good returns to the investor. Since traders are light on their positions & not really bearish of the debt markets; any positive cues will help the yields to start easing off.

All I am trying to say here is that no portfolio will have more than 10-20% allocation to long term G-Secs. For that portion adopt the strategy suggested by me. Also, take advantage of higher yields and lock in your portfolio in 6-12 month FMPs (based on your cash flows) as these higher yields will not last for too long. Hence invest in long term FMPs that will be launched from now to say end October which will have the opportunity of capturing higher and higher yields.

POST THE RBI CREDIT POLICY REVIEW & ITS IMPACT

• Credit policy is out the way
• Sentiments have gone negative & frequent utterances by RBI officials on giving priority to tackling inflation first and accordingly ensuring that liquidity does not come back into the system in a hurry has also not helped matters
• RBIs clear intention is to tackle inflation first & hence some more rate hikes in the near future
• As mentioned in my previous note on the eve of the policy all the other fundamental and macro reasons still remain the same
• Our system is currently short of liquidity by Rs 40,000 – 60,000 crore.  I believe, with this move of increasing the rates, the tightness in the liquidity will continue to remain for some more time.  Till we see aggressive spending or reduced borrowing by the government, the liquidity will not return in the system, thus keeping the short term rates elevated
• Govt. borrowing programme has been front loaded with 40% already completed reducing pressure on the latter part of the year
• Inspite of the fact, the 10 yr benchmark has inched-up to 7.85-7.86 % levels, I would treat these as investment opportunities to further increase exposure in the longer end of the curve
• I don’t know whether 10 yr benchmark will peak off at 7.80 or 7.85 or 8 percent level hence I would advise staggered investment in gilt schemes at various levels starting from now
• I would recommend not to invest in bond funds for two reasons :

1. There would be exit load issues if one invests in bond fund
2. Post the RBI policy review there is a possibility of spread widening between GSec and Bonds going forward

Also, I would recommend that your investment in long term portfolio also should be staggered on weekly basis starting now instead of parking your funds in say 3/6 month FMPs and losing out on opportunities coming your way. Please park that portion of funds in respective liquid plus schemes of those MFs in whose GILT Funds you would like to take exposure to & give weekly switch requests to switch into their G Sec Schemes starting now & staggered till say 3 to 4 months hence. i.e. say if you wish to invest Rs12 Cr in GILT, invest Rs.75 lacs to Rs.1 Cr every week from now to 3 to 4 months hence through Systematic Transfer Plans (STPs). This way you will average your investment without trying to time the market at the same time participate at every high levels of interest rates from say 7.80% to say 8% levels.

Also, 3 to 4 month horizon will take care of any intermittent rate hikes as well as October Credit Policy review.

ON THE EVE OF THE CREDIT POLICY REVIEW-AN AGGRESSIVE CALL FOR INVESTMENT IN LONG END OF THE CURVE

Kindly refer to my blog note dated July 12’2010 “GREAT OPPORTUNITY AT LONG END OF THE CURVE”. I had given various reasons for my belief of investing at the long end and had suggested a staggered investment from then to run upto the Credit Policy Review on July 27’2010.

As suggested in that note, 10 year benchmark in anticipation of further rate hike expectations have inched up from 7.65% to currently closer to 7.70% levels.

What is the way going forward from hereon:

Negatives in the market:

1. Inflation to further rise to closer to 12.25 to 12.50% & peaking off at these levels
2. Maybe erratic monsoon as seen in some of parts of the country & its repercussions
3. Further rate hikes in the future (taking the overall rate hikes for the year to between 125 to 150 bps as compared to last year)
4. Since 2003 when the interest rates were at their lowest & thereafter either remaining steady or only going upwards, Short Term Schemes as an asset class has outperformed long term GILT & Bond Funds on 1/2/3/5/7 year time horizons; dissuading clients to take unnecessary duration or interest rate calls

Positives in the market:

1. More than expected hefty revenue collections from 3 G/BWA Auctions, better than expected tax collections due to better corporate results. This still does not include any revenue collections from PSU disinvestments
2. Mechanism announced to free the petroleum pricing; thereby hugely reducing petroleum subsidy figures
3. Possibility of more foreign inflows expectations due to up gradation of GDP numbers by IMF
4. IIP numbers easing from a high of 16.5% to currently at around 11.5% & likely to go further down to single digit figure
5. After peaking off at maybe 12.50%; inflation to soften due to base effect kicking in & going to higher single digit by September & to approx 6-7% by March 2011
6. Demand/Supply of G Sec becoming more skewed in favour of demand in the year 2010-2011 than supply (reverse was the case for FY 2009-2010)
7. In almost 6-7 years’ deposit growth is much lower than the credit growth. This can be attributed to aggressive borrowing by the Telecom Companies & also aggressive borrowing by corporates at large before the Base Rate policy becoming applicable on August 01’2010
8. Even though there is merit in the argument that Short Term as an asset class has outperformed long term bonds or long term G Secs; there have been periods in which long end of the curve has hugely outperformed any other asset class including equities. Typical example is when we had recommended investment in long end in November 2008 & thereafter we had given an aggressive disinvestment calls between December 2008 end and January 2009 beginning by which time the investments in long term G Sec schemes had been hovering in the region of 20-25% absolute returns
9. Hence, even going forward, one will have to be nimble footed and take advantage of this trading zones which comes up every once in a while
10. I personally believe that we are in that trading zone range, wherein investors investing at current levels of 7.69-7.70% levels can expect, for reasons mentioned above, 10 year benchmark to soften further to between 7-7.25% levels by March 2011
11. One need not literally have one year view and hold onto these investments for one year. Investor need to cash onto these opportunities & redeem (even if there are exit loads applicable in some long term bond funds) as & when they have managed to earn more than expected returns from this asset class

GREAT OPPORTUNITY AT LONG END OF THE CURVE

I have been giving investment calls in Long end of the yield curve from time to time giving various reasons for the same. Last year I had spoken about this on numerous occasions (some of my reference notes for your perusal are my blog entries dated September 07’2009 titled “SHOULD ONE TAKE CONTRARIAN CALL & INVEST AT THE LONG END OF THE CURVE? & another Blog entry of December 07’2009 titled: ONCE AGAIN AN INVESTMENT OPPORTUNITY AT LONG END-WHEN? & WHY ?

I had given several reasons for propagating these contrarian views. Some of them were technical and some of them were fundamental economic reasons. Most of these reasons are panning out quite well.

Some of the main reasons cited were:

1. Technical reason when differential in overnight rates & 10 year benchmark were at all time historical high of 425 bps in the month of September’2009
2. Lower credit offtake figures when I had written in December 2009
3. We were hoping for a lower petroleum subsidy figures for FY 2010-2011 after an announcement by both Petroleum Ministry & MoF who were working on a joint formula for a sustainable oil subsidy
4. Fiscal stimulus roll back resulting in better revenue collections
5. Higher GDP growth expectations again resulting in better revenue collections
6. 3 G Auction and disinvestment of PSU stocks; helping reduce Fiscal Deficit numbers

Where do we stand now as far as above points are concerned:

1. Historically overnight rates and 10 year benchmark rate differentials have been hovering between 135-150 bps. Currently due to tightening of the liquidity & subsequent increase in overnight rates to 5.50% to 5.60% & 10 year benchmark at around 7.65% this differential is at 200 bps. Once the systemic liquidity improves due to Govt spending, G Sec redemptions of almost Rs.50,000 crs in the current month & RBI paying dividend to the Govt of close to Rs.25-30,000 crs the overnight rates will start easing off & will come closer to the Reverse REPO rate of  4%  . This will then widen gap once again between overnight/10 year benchmark to 3.5% to 4% levels giving rise to a technical rally to reduce this gap.
2. Ministry of Petroleum has already announced a formula to go towards free pricing of petroleum products in a phased manner. As the first phase, they have already hiked both petrol & diesel prices. This will go a long way in reducing petroleum subsidy figures & help in fiscal consolidation. Great for long end of the curve.
3. Fiscal stimulus roll back announcements in the Budget is already accounted for in the borrowing programme numbers for the current fiscal year
4. Higher GDP numbers have already been translated in higher tax collection figures. Corporate tax collections have grown by 21.7% in first quarter & advance tax collections for Q1 of current year are already up by 31.4% compared to Q1 collections of last year.
5. More than triple the estimated collection figures of more than Rs.1 lac crs in 3 G & BWA Auctions have made  the Govt coffers richer to that extent & helped in improving country’s fiscal position
6. IMF has upgraded India’s GDP growth rate from 8.80% to 9.40% for 2010 in its July release of world Economic Outlook on back of robust corporate profits & increased Govt thrust on investments & reforms.
7. This could result in rerating of Indian Companies leading to better fund flows into India. Another positive for long end of the curve.
8. Since the Govt borrowing programme was front loaded; hence second half will be a much lighter borrowing calendar.
9. With so much of positive revenue flows from all quarters there is a talk of reducing borrowing in the second half ; which can be a great sentiment booster for the debt markets
10. Though inflation numbers are a concern with likely hood of one more rate hike in July end Policy Review, with good monsoon & base effect kicking in from August onwards, inflation numbers will start easing off.

Hence, any investor with 9-12 month horizon can look to invest in long term bond funds (which will have higher carry than long term G sec funds) & Long term GILT schemes. I expect the 10 year benchmark yields after peaking off some time by July end should start easing off for all reasons mentioned above & can come down in the range of 7.25% to 7.50% by March 2011. Even currently as being noticed, even after the rate hike, 10 year benchmark has marginally gone up to 7.65% from 7.58 to 7.60% levels. One can start investing in tranches from now and July end.

MY COMMENTS IN AN ARTICLE IN ET MUMBAI