Summary

• Stress in the bond and particularly exchange rate markets persisted in June due to rising inflation and commodity/oil prices.Retail inflation in May rose to a four-month high of 4.9% from 4.6% the month before.
• Anticipating acceleration in inflation and reacting to the steeper trajectory of Federal Reserve (Fed) policy rates, Reserve Bank of India (RBI) had already raised the policy rate by 25bps early in June.But the Indian rupee (INR) continued to depreciate as foreign investors pulled out US$2bn from India’s debt and equity markets.
• Wild card risks that could buffet India in the months to come include: oil prices, monsoon rains, government set minimum support prices (MSPs) of cereals, impending global trade wars and political developments ahead of 2019 general elections in India.In view of these risks, the Fund has cut the duration of its portfolio.

Market update

Bond markets opened the month on a cautious note ahead of RBI’s Monetary Policy Committee (MPC) meeting on 6 June.  A depreciating Indian rupee (INR), rising oil prices, uptick in April’s inflation, and robust growth in  the first quarter of 2018 intensified fears of a policy rate hike.  RBI obliged by raising the policy rate by 25bps to 6.25% on 6 June.  It also revised upwards its inflation projections for both the first and second halves of fiscal 2019, ending next March.  In response, yield on the benchmark 10 year Government of India (GOI) bond touched 8%, up 26bps from its level at the end of May.     

Bond market sentiment was further damaged by RBI’s introduction of mark-to-market (MTM) methodology in valuing state government securities.  Until this new regulation, these bonds were valued at a uniform mark-up of 25bps above the yield on the central government securities of the same maturity.  Since state government bonds typically trade at a spread of 50-60 bps above Central government securities, the new norm takes away the MTM provisioning cushion that banks enjoyed thus far in the valuation of state bonds.

Inflation data released towards mid-May confirmed RBI’s caution.  Consumer price inflation rose to 4.9% in May from 4.6% in the prior month. Core Consumer Prices Index (CPI) (excluding oil and food) accelerated to 6.2% in May from 5.9% in April. Furthermore, wholesale price inflation also rose sharply to a 14 month high of 4.4% in May from 3.2% in the previous month. Even though both Wholesale Price Index (WPI) and CPI had unfavourable base effect built in, the bond yields remained elevated.

Yields softened as oil prices and US treasury yields fell in the third week of June. RBI also announced an INR100bn Open Market Operation on 19 June. As a result, the pressure on yields subsided. But yields inched up again towards the end of the month as volatility in oil prices increased. The delay in Minimum Support Price (MSP) announcement also added to anxiety amongst market participants.

Performance

The 17bps rise in yield on the benchmark 10 year GOI bond in June coupled with a 3bps increase in AAA-rated 10 year corporate bond spread led to a 0.17% reduction in the Fund’s Net Asset Value (NAV) in INR terms. But INR depreciated 1.51% against the US dollar during the month, which resulted in the Fund returning -1.68% in US dollar terms. 

Strategy

While the Fund was looking to extend duration at the beginning of June, that thinking changed as global uncertainties intensified, RBI raised the inflation forecast as well as the policy rate, and the US Fed signalled a steeper trajectory of policy rates in 2018 and 2019. Oil prices and trade conflicts headline global uncertainties. Despite the Trump administration’s pressure on Saudi Arabia to raise oil production, it is far from clear if the resulting production hikes will be large enough to offset declines in supplies from Venezuela and Iran. Trade conflicts between the United States and the rest of the world could also degenerate into an outright trade war. In such a clouded environment, the Fund has now adopted a defensive posture by cutting duration. In June, the Fund sold a Power Grid bond due in 2029 and purchased a GOI bond maturing in 2022.