India Fixed Income Opportunities Fund - July 2019

 

Summary

  • Increasing growth concerns in global and domestic markets dictate performance across asset classes.
  • Recent credit events in India have increased growth risks and have now generated a strong government policy response to break the logjam.
  • Benign inflation expectations and their implication for high real rates, a steep yield curve and high-grade credit spreads continue to drive our positive view on the total return opportunity in debt markets.


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Market update

Globally, markets experienced increasing growth concerns and a high volatility risk environment highlighted by US-China trade developments, rising US-Iran tensions and a 9 -month extension of crude production cuts by 21 nations (including OPEC members). Earlier, US-Canada and now US-Mexico struck a bilateral deal to avoid tariffs but there has not been an optimistic correlation to the US-China negotiations. These growth impediments fueled a sharp rally in bond markets with US 10-year treasury yields below 2% for the first time since 2016. The Fed Futures market now indicates almost 100% probability of 25bps rate cut in the July 31st meeting.

India’s economic activity has cooled as well, dragged by cuts in leveraged private consumption (autos and residential real estate) and tight control in government expenditures. This however was a well understood risk for two quarters and equity markets were showing signs of a post-election pivot. But recent credit events, despite a sharp reversal of liquidity from deficit to surplus and ongoing policy rate cuts, have emerged as the biggest negative surprises. Incremental funding from bond markets to NBFCs/HFCs has been virtually non-existent, with mutual fund debt AUM stagnating. Mutual funds have been cutting exposure to NBFCs/HFCs following payment delays/defaults by large companies, which include Dewan Housing Finance, the entire Anil Ambani group of companies and a few SME’s.

In other economic new flows, IIP growth bounced back to modest 3.4% in April from flattish numbers for the previous two months. CPI inflation for May inched marginally higher to 3.05%, versus an upward revised print of 2.99% in April, but remains well below the RBI target. The RBI now expects 1HFY20 CPI inflation at 3.0-3.1% and 2HFY20 inflation at 3.4-3.7%, with risks broadly balanced. GST collections for May came in at INR 999bn, implying a 3MFY20 run-rate of INR 891bn (post refund) and well short of the required rate of INR 1.15tn. Lastly, the monsoon season has started after a delay projected by various weather agencies. Until June 26th, cumulative rainfall was 21% below normal and spatial distribution is deficient across India, with 3 subdivisions out of 36 receiving scant rainfall and 20 out of 36 at deficient rainfall.

The supportive trends in global markets lent assistance to the third consecutive policy rate of 25bps by the Monetary Policy Committee, with the latest cut bringing policy rate down to 5.75% and a change in stance from ‘accommodative’ to ‘neutral’.

In June, FPIs bought stock worth US$225mn and debt worth US$1.2 bn. FPI flows have remained strong with YTD flows at US$12.8bn amid the possibility of continuity of incumbent government and policies. This has helped with INR stability, with modest bias towards appreciation being supported by stable crude prices and a stable non-oil trade deficit. Additionally, exit quarter trends are indicating a possibility of even improvement.

Performance

June saw yields on G-Secs rally by 10-20bps, with the yield on 10-year rallying from 7.27% to 7.07% and 3-year rallying from 6.68% to 6.58%. Credit spreads have remained wide and have retraced their March-April easing, bringing them closer to the widest points in history. Spreads on 5-year AAA and AA rated corporates widened from 102/167bps to 114/169bps respectively. More importantly, spreads for NBFCs, which provide 18% of credit, are wider by 20-27bps. Spreads on 5-year AAA and AA rated NBFC widened from 119/192bps to 134/196bps respectively

The Fund was down -0.53% in USD terms, supported by a 0.96% appreciation in INR-USD. The relative performance was brought lower by the pricing of the Fund’s smallest portfolio holding, a secured, non-convertible debenture by Dewan Housing Finance Corporation (Dewan). Dewan NCD took a steep knock on pricing at the start of June due to a payment delay from NBFC liquidity issues, triggering a technical default and downgrade by rating agencies (AAA at issuance). Dewan honored the payment within the 7-day grace period, but subsequently delayed payments on 2 more bank credit lines. A lender consortium of 31 banks, accounting for roughly 40% of Dewan’s balance sheet, has started work on a resolution plan. Given the secured nature of the bond the Fund holds, the bonds principal is expected to be fully protected; however, this event has contributed to a drag on the bonds performance in the past month. Adjusted for the Dewan bonds mark, the Fund modestly outperformed in comparison to the Indian credit benchmark.

Outlook

Looking forward, we remain constructive on debt markets as both yields and spreads are expected to rally and drive positive returns.

The G-secs have rallied sharply in last 2 months, but we see room for further appreciation with potential for one or two more policy rate cuts. We find the latest union budget issuance schedule to be slightly bullish with revised targeted fiscal deficit at 3.3% (of GDP) versus 3.4% in the interim budget and market expectations of 3.5%. We do see some risks to revenues from a lower run rate of GST tax collections and higher capital receipts from divestment and dividend payments from the RBI. These risks can be partly offset by tight controls on social welfare spends, specifically lower farm income support pay-outs. We are also inspired by a government proposal to issue G-Secs in foreign currency for first time in its history. This speaks volumes on India’s confidence in its macro-stability and a more diversified investor base for G-Secs over the longer term.

Credit spread tightening will require the current economic picture to clearly improve, but in the meantime, provide attractive income. The latest budget proposal will slowly but surely revive liquidity, credit spirits and growth in due course; with the aim of recapitalising government owned banks by INR 700bn and one-time 6 months partial credit guarantee for first loss up to 10% on pool assets worth INR 1tn from NBFCs.