Bond yields have corrected below that 6% level post RBI’s Operation Twist and the HTM limit relaxation as well. What is it that your outlook is on some of these measures and when do we see the yields settling especially when the fiscal deficit is likely to remain elevated?
It is interesting that we have had these pulls and pressures on both sides of the market. We have seen a fair amount of volatility but eventually the 10-year G-Sec seems to be settling down around the 6% mark. What seems to be happening is, of course, over the last several months now, we have had this extraordinary spate of rate cuts and open market operations of various kinds which has added to liquidity. In the ordinary course of events, we should have seen yields come down but they have been stuck at 6%. In fact, they were at 6% six months ago in ore-Covid times.
It suggests that the market is worried about the fiscal position. Even the RBI has signalled both sides that is to say on the one hand, where yields rose above the 6.20 mark, they intervened to calm them down but at the same time it does not look like they are going to push yields significantly lower than 6%.
A number of measures have been doled out by the Reserve Bank in addition to the recent OMO operation. About Rs 10,000 crore worth G-Secs weer bought by RBI. Do you see more such measures?
RBI is in a difficult spot when it comes to open market operations because on the one hand they do need to do OMOs to support the G-Sec markets to keep a lid on yields and on the other hand, they have realised that keeping liquidity in excess for an extended period of time could in itself become inflationary over a period of time.
Given that already CPI inflation is somewhat uncomfortably high, they are going to find it difficult to sustain doing direct OMOs. So the switch from OMOs to Operation Twist which is relatively liquidity neutral is a very important signal.
The second signal, of course, is the fact that they seem to be intervening less in foreign exchange markets and allowing the rupee in some sense to appreciate a little. These two steps in some sense have to be seen in this context of elevated inflation and RBI not wanting to significantly add to liquidity in the markets. Therefore you do see RBI intervening through OMOs more in the nature of Twist which should keep a reasonable lid on yields. But we should not expect the RBI to do outright open market operations unless we see shrinking of the monetary base. I would imagine one such shrinkage of the monetary base could be the reversal of some of these LTROs. We will have to wait and see how that pans out.
What about investments in fixed income and what opportunities do you think emerge from investment both at the longer end of the curve as well as the shorter end?
A lot of value is actually seen at the longer end of the curve because the short end of the curve has really reacted a lot to these extraordinary monetary policies. We have seen yields across the shorter space. The money market and let us say short term bonds up to five years really have not fallen in the last six months while the 10-year or longer actually have not reacted at all. So there is a lot of value in the longer end of the curve as these situations normalise.
For example, in the next couple of years, we should expect the fiscal position to improve as tax collections get better because a large part of the expansion in the fiscal deficit this year is on account of weaker tax collections projected and that should change.
Secondly RBI will start to withdraw this kind of extraordinary accommodative monetary policy in the next two years and this should lead to a more normal yield curve instead of this extraordinary steep yield curve that we have seen.
What kind of return expectations should one have now from fixed income?
One of the fundamental things is that in the last two years, we have seen this huge drop in rates. 10-year G-secs were above 8% in 2018 and now they are at about 6%, the short end of the curve. AAA corporate bonds four, five year have fallen from 8.75% levels to closer to 5%. We have seen this extraordinary softening of yields in the last two or so years. And that means the returns from bonds have been fantastic.
Going forward we are not going to see that, the rate cut story has come close to an end and we should expect that in the next two or three years, RBI will need to be on a rate hike path. That means we will now have to start building portfolios which are resilient to rate hikes and which can hold value even if the rates start moving up.
The return from here on will look more like yields on portfolio simply because the capital gains will come closer to an end. There are no promised returns in capital markets and so there is no way to know for sure but my expectation is that we will be looking to deliver some kind of small alpha over the yield on the portfolios through these active strategies. But the one sided capital gains story of the last two years has come to an end.
What about asset allocation within fixed income as well in terms of which funds and also between fixed income and equities? What kind of proportions would you recommend at this point?
Within fixed income, investors have become very overweight on short term AAA corporate bonds and that is where we see a lot of flows which have come into the mutual fund industry and even with us at Axis. But investors should start looking outside that. We see a lot of value in long duration securities. We also see value in non AAA credit space but again we have only seen outflows over the last six months or so.
My expectation is that as the economy starts to improve and macro conditions start to improve, this will also feed through into credit and as long as we are really selective about what we are owning, that has significant value. So we should expand our basket of investments within fixed income to make sure we have a balance of assets.
The only segment which I would be underweight in is probably three to five year sovereigns and AAA which I think are overvalued in the current environment. Other than that, I see a lot of value in fixed income. When it comes to equity versus fixed income, it is a very different take, I think, equity markets are pricing in a very different environment from what debt markets are pricing in.
Bond markets are still concerned about the state of macro, it is not that we are seeing that growth is really roaring back while in equities it is a very different take. Equity markets are in some sense reflecting the fact that. At the end of the day, an equity index is reflecting the fortunes of the top 50 or 100 or maybe a few hundred corporates and consolidation of business that we have seen in the current environment with the lockdowns affecting the smaller businesses much more than larger businesses. So consolidation means that the equity indices are doing well.
We have a very interesting state of affairs and I believe that in equities, it is a case of finding earnings growth. You can find earnings growth going forward, on fixed income. It is more about preserving value and trying to find a few small hedges. As always, the asset allocation recommendation is very personal but I would say that having a balance in your portfolio makes a lot of sense.
What is your advice to investors in terms of the asset allocation between fixed income and equities?
It is important to have your own risk balance and therefore your own asset allocation in mind at this point of time. Do not change asset allocation just on the basis of market movements. You have seen some extraordinary volatility on both asset classes and extraordinary policy outcomes in both asset classes. This is not the time to change your poor asset allocation. If you had a mix going into this pre-pandemic and it was 60-40, then please maintain your 60-40 or whatever asset allocation you had. I do not believe that you should change your asset allocation based on market movements.
The second point is that we are also not seeing extremes in valuation when it comes to fixed income which is my forte. The markets are reasonably valued and so we are not seeing a trigger which suggests that you should be significantly overweight or underweight fixed income, which could give you the opposite view on equity. I would still suggest that there is significant value in fixed income and I would say maintain more of a balanced portfolio.