Summary

• May was yet another month of weakening bond prices amidst limited volumes. The market faced significant global headwinds from rising oil prices and a sharply appreciating US dollar. The acceleration in April’s headline and core inflation added additional downward pressure on bond prices.
• As markets began to weaken, foreign portfolio investors (FPIs) pulled funds out of India’s debt and equity markets, further compounding the market weakness. The offloading of positions by traders ahead of the monetary policy meeting on 6 June led to further increase in yields.  
• Even if the Reserve Bank of India (RBI) fails to provide quick liquidity support to debt markets by announcing frequent purchases of Government of India (GOI) bonds, we believe that rates should decline over time as inflation wanes in the wake of normal monsoon rains. Furthermore, the impending trade war is likely to lower global growth and siphon off pressure from global and US policy rates.

Market update

Yields fell by 25bps to 7.58% in the first week of May. RBI’s decision to lift the three-year residual maturity constraint on FPI purchases on Indian bonds raised hopes of increased flows of overseas funds in the domestic market. The favorable impact on bond yields, however, proved transitory. The pessimism returned in the second week of the month. The sharp depreciation of Indian rupee against the globally strong US dollar, anxiety over US President Trump’s decision to pull out of the Iran nuclear deal, and the subsequent increase in crude oil prices pushed yields to upwards of 7.90%.

Yields softened a bit in the second half of May, but the overall hardening bias persisted.  CPI release for April 2018 stood at 4.58%, 30bp higher than its level in March.  Pressure on inflation emanated from the food and services components.  Ex-food and energy “core” inflation also accelerated to 5.92% in April, up from 5.37% in March.  In response, market participants raised the probability of a rate hike by the RBI in the monetary policy meeting on 6 June. The release of GDP data for the quarter ended 31 March 2018 lent further credibility to the prospects of tighter monetary policy - GDP growth accelerated to 7.7% on the back of a significant pick-up in investment activity and government consumption expenditure. 

Performance

The 6bp rise in yield on the benchmark 10-year GOI bond in May together with a 7bp increase in AAA-rated 10-year corporate bond spread led to a 0.19% reduction in the Fund’s NAV in Indian rupee terms.  Furthermore, Indian rupee’s 1.1% depreciation against the US dollar meant that the Fund returned -1.29% in US dollar terms. The Fund’s year-to-date total returns are -4.94% in US dollar and 0.50% in India rupee. 

Strategy

All eyes are now on the monetary policy meeting on 6 June. Any announcement of frequent RBI buy-backs of GOI bonds will drive bond prices higher. Beyond any short-term liquidity management, however, the evolution of CPI in the second half of this fiscal year is more relevant for bond markets. We foresee two encouraging developments in this context:

• CPI is likely to recede later this year if the on-going monsoon season remains on track and as the inflationary impact of the Seventh Pay Commission mandated salary increases begins to wane beyond September.
• The impending trade war following the Trump Administration’s tariff decisions may slow down US and global growth, making sharp policy rate hikes redundant. That would open up room for the RBI to cut rates.

In view of these expectations, the Fund will extend its duration at the margin. As for hedging the currency risk, we continue to believe that currency weakness this year is driven by outflows of portfolio capital from India’s capital markets just as it was during the period of “taper tantrum” in 2013. Most of the sharp India rupee depreciation in the first eight months of 2013 was reversed in the subsequent seven months. If anything, India’s economic fundamentals are stronger at present than they were in 2013 and hence, we expect the Indian rupee to fully recover the lost ground once capital flows normalize.