Global and Indian debt markets performed strongly in December due to the US-China trade war and continued US Federal Reserve interest hikes.

Summary

• Global debt markets performed strongly due to the following; Ongoing US-China trade concerns clouding the growth outlook for the two largest global economies, a steep correction in crude prices indicating a broader slowdown, and dovish talks by US Federal Reserve (the Fed) on incremental tightening.
• Indian debt markets mirrored the global trends with incremental support coming from modest but broad-based weakness in India’s economic growth, significant softening in CPI, as well as liquidity injections from the Reserve Bank of India (RBI). Less supportive factors were fiscal deficit concerns ahead of the general elections in May and a higher borrowing program from state governments in the last quarter of the fiscal year.
• The Fund is constructive on debt markets in 2019 with opportunity to play long duration strategy in both a benign inflation and high real policy rate environment as well as in credit spreads, since current spreads are at the higher end of historic range despite a resilient credit outlook.

Market update

Debt markets shine in a murkier global growth outlook:

• Global equity markets were extremely volatile, led by increasing growth anxieties surrounding US-China trade tensions, a growth scare driven decline in crude prices, and dovish statements by the Fed. The outcome of these events was a 28-bps drop in 10-year US Treasuries in December.
• India was not immune to the global uncertainty as growth challenges emerged due to weak demand for consumer durables, unexpectedly weak performance by the Bharatiya Janata Party (BJP) in state elections in Chattisgarh, Madhya Pradesh and Rajasthan as well as a new RBI governor following the abrupt resignation of Dr Urjit Patel.
• The biggest driver for Indian debt markets was the steep fall in crude prices (dated Brent was down 8.4% for the month, and down 38.3% for the quarter), significant softening in consumer price inflation, and strong liquidity support by via the RBI’s open market operations in government securities. Headwinds were fiscal management as ongoing softness in GST collections was exacerbated by cuts in GST rates on select items, the government’s commitment to a large recapitalization program for state-owned banks and increasing pressure to tactically follow populist policies ahead of general elections. Tailwinds prevailed, and G-secs rallied for a third consecutive month with the yield on 10-year G-secs was down 24 bps for the month and down 65 bps for the quarter.
• Corporate bond markets were relatively flat as credit spreads remained tight, despite being at the higher end of their historic range on lingering effects of the IL&FS default and a larger borrowing program from the state governments in last quarter of this fiscal year.
• The Indian rupee benefitted from the sharp fall in crude prices and relief from cross currency trends (dollar spot index DXY was down 1.13% and JP Morgan Emerging Market Currency Index was down -0.42%). The rupee fell a modest 0.17% in December following its extraordinary 6.10% November gain.
• Foreign portfolio flows have returned after peaking of crude prices and mean reversion in currency. December saw net buying worth US$671m from FPIs.

Performance

On a point-to-point basis, the benchmark 10-year yield on government bonds fell by 24bps from 7.61% to 7.37%. Conversely, the spread on 10-year AAA and AA corporate bonds widened by 19 bps from 98 bps to 117bps and by 24 bps from 155 bps to 179bps respectively. This resulted in gains in NAV at 0.92% in rupee terms.

A 0.17% Indian rupee depreciation versus the US dollar capped the NAV gain of US dollar 0.75%. Year to date, the Fund’s NAV is +4.02% in INR terms and - 4.90% in US dollar terms, when adjusted for the 8.58% Indian rupee depreciation. The cash level in the Fund has gone up to 11.1% on the redemption of bonds by IDFC Bank and Indian Railways Finance Corporation (3.4% of the fund AUM each).

Strategy

The Fund Managers are constructive on debt markets in 2019;

• The positive view on bonds is led by deflationary forces on supply side of crude, increasing odds for fewer and slower paced rate increases by the Fed, rate hikes expectations for 2019 are down from three to two, potential for a cut in policy rates by the RBI given high real rates (policy rate at 6.5% against exit month CPI at 2.3% and fiscal year end inflation estimates of 2.7-3.2%), mild headwinds to Indian rupee, and modest slowdown in GDP growth which may induce a change of stance on monetary support.
• The Fund was aggressively positioned with higher exposure to corporate bonds, 63% of AUM at the end of previous quarter. This share of corporate bonds has dropped to 53%, due to the maturity of corporate bonds by IDFC Bank and Indian Railway Finance Corporation and the larger share of income distribution in this period and relative underperformance of corporate bonds post the IL&FS crisis.

• Deliberating between duration strategy versus credit spreads, the Fund bought one lot of long duration G-Secs with 2035 maturity in December. The Fund is continuing its credit research and will use this cash as and when it finds appropriate opportunities.