Summary

• Yield on the benchmark ten-year Government of India (GOI) bond went up by 13bps in September following a 9bps hike in August. Lower than expected GDP growth in the April-June 2017 quarter as well as persistently weak data on industrial production failed to raise the odds of an imminent policy rate reduction since retail inflation rose yet again in the latest data release.
• Official comments hinting at a fiscal stimulus to promote growth further dampened sentiment in the domestic bond market as it raised concerns of a fiscal overshoot.
• Despite rising yields on GOI bonds, corporate bond spreads fell by 11bps last month on top of a 19bps decline in August. This reflected continued Foreign Portfolio Investor (FPI) interest in corporate bonds. Although FPIs invested US$164mn in debt markets, they siphoned off US$1.65bn from the equity markets. In response, INR depreciated -2.13% against US$ during September.

Market update - accelerating inflation

Lower than expected GDP growth in the first quarter of the current fiscal year had revived hopes in early September of monetary policy easing as early as the meeting of the monetary policy committee on 4 October. However, several factors contributed to dashing these hopes:

• Consumer price inflation (CPI) increased sharply to 3.4% year-on-year (YOY) in August from July's 2.4%. 
• More importantly, core inflation (excluding food and fuel) increased to a 4-month high at 4.5% YOY from 3.9% in July.  
• Wholesale inflation (WPI) also increased to 3.2% YOY in August, up from 1.9% in July, driven mainly by food prices. This suggested more retail inflation in the pipeline.
• Sentiment in the bond market turned increasingly bearish after Finance Minister Arun Jaitley hinted at a INR650bn fiscal stimulus package to revive GDP growth. This fed fears that India might overshoot its fiscal deficit target of 3.2% of GDP for the current fiscal year 2018. 

While the above factors led to a significant rise in yields on GOI bonds, corporate spreads fell by 11bps last month thanks in part to continuing FPI interest in the asset class. Reflecting this strong interest, FPIs bid aggressively in the auction of corporate bond limits on 22 September. The cut-off was just over 50bps. We concur with the belief from FPIs that corporate bonds still offer investors attractive returns. Immediately following the limit auction, the government tweaked rules to raise the corporate debt limit for FPIs by INR 440bn (US$6.79bn) in a staggered fashion.

Although FPIs brought US$164mn into India’s debt markets in September, they withdrew US$1.65bn from equity markets. Disappointing growth suggested weak corporate earnings for at least one more quarter. The overall negative fund flows plus widening of the current account in the June 2017 quarter to 2.4% of GDP from 0.6% of GDP in the previous quarter resulted in a sharp -2.13% depreciation of the Indian rupee against a globally strong US dollar. 

Performance

Although the Fund’s NAV fell by -2.18% in September, almost all of that loss can be attributed to the INR’s depreciation against the US$. The Fund was down only 5bps in INR terms. While the rise in yields on GOI bonds was a drag on the Fund’s performance, the 11bps decline in corporate spreads minimised the adverse impact. After all, 55% of the Fund’s AUM is invested in corporate bonds. 

Strategy

Towards the end of September, the Fund sold three GOI bonds in its portfolio with the intention of buying corporate bonds in early October when the corporate bonds become freely available on demand. This strategy is aimed at picking up spreads on corporate bonds of up to 70bps on AAA-rated and 140bps on AA-rated bonds.