The Fed Lift-off

Markets could not be more divided on the Fed rate decision due tomorrow. While about a month back, most did expect a "lift-off", the global risk-off sentiment and increased volatility have reduced the odds of a rate hike tomorrow.

Following are my thoughts on the rate hike, if any tomorrow, and the subsequent outlook ahead:

1. Inflation is one among the two metrics often cited as key by Fed officials. With the latest print at 0.3% which is far away from their 2% target would have made markets infer that rate hikes are far off. However, some of the Fed officials such as Stanley Fischer have commented that Fed might overlook the current dip in inflation as owing to global commodities cool off which would base out and that inflation (PCE) would reach 2% in 2017.  A brief analysis of the TIPS market against the US treasuries would lead one to believe that 2% is possible only sometime in 2020. If Fed is right, TIPS traders are just morons to sell them and the whole world should be loading up on TIPS.

2. There has been a consistent debate over U3 vs U6 employment rates in US and how the often reported U3 unemployment rate might hide the lack of wage pressure owing to a larger (and wider) U6 unemployment. If wage pressures are not coming through, I just do not see inflation picking up. Somewhere, the great minds at Fed should have to clarify their inflation targets in a believable way before hiking rates.

3. Market is tired off the uncertainty around what would happen after the lift-off. Most participants would not care a damn about the first hike of 25 bps; as the monkey off the shoulder feeling could release risk appetite back into the market.

My expectation of what would happen tomorrow,
Case 1: 25 bps hike with a reasonable clarity that no more hike is due this calendar year and further action to be done in Q1 of 2016. And some pieces thrown about increased volatility in world markets.
Case 2: No hike citing the volatility in the markets; but still optimistic about growth in US. Keep options open for October/December rate hike.
Case 3: No hike citing the uncertainties from the mayhem in world markets and their likely impact on growth and inflation expectations in US.

My base case is the first one. The third one is an extreme case which can lead to large scale risk-off mood. The second case just postpones the current uncertainty down the line.

RBI - it is time to ease, ease aggressively

RBI in its last monetary policy statement highlighted four key items to track for continuation of the easing stance:

1. RBI will await the transmission by banks of its front-loaded rate reductions in January and February into their lending rates This seems to be a debatable issue as some banks argue that in the rate hiking cycle starting from the middle of 2013, they have not passed on the repo rate hikes into base rates, and hence their not easing base rates when repo rate has been cut is not entirely unreasonable. This link provides the recent history of SBI base rates, it is noteworthy that the base rate was 9.70% in 2013 when repo rate was at 7.25%, and now the base rate is 9.80% while the repo rate is at 7.50%. It can be argued that the banks absorbed the repo rate shocks and kept managed the lending rates In the banks' defense, they have passed on 15-20 bps since the April policy. It is for RBI to think why their monetary transmission is not working to the extent they expect. In my opinion, this item of RBI Governor is very debatable and can be overlooked depending on how the other factors are panning out.
2. Developments in sectoral prices, especially those of food, will be monitored, as will the effects of recent weather disturbances and the likely strength of the monsoon, as the Reserve Bank stays vigilant to any threats to the disinflation that is underway. The Reserve Bank will look through both seasonal as well as base effects. CPI and food inflation have not misbehaved in the latest print of Apr 2015, and it seems the Government has managed to keep the inflation, food inflation in particular, under check. RBI's fear in this regard has not materialized.  Regarding the likely strength of monsoons, there have been mixed research reports: There is enough differences among the professional weather forecasters, some of whom call for a normal monsoon and while others call for a deficient one. Weighing in the two sub-items: nonseasonal rains have not impacted inflation, while the monsoon status remains unknown - this is no case for not easing rates.
3. RBI will look to a continuation and even acceleration of policy efforts to unclog the supply response so as to make available key inputs such as power and land. Further progress on repurposing of public spending from poorly targeted subsidies towards public investment and on reducing the pipeline of stalled investment will also be helpful in containing supply constraints and creating room for monetary accommodation. This is yet another area where the Government has pushed ahead with some items while showing full intent in the stuck areas as well. Coal auctions have been a silent success while delays in land reforms are a loud failures, though the Government is working hard for resolution.  RBI should have no doubts with respect to the intent of the Government in this regard. 
4. Finally, the Reserve Bank will watch for signs of normalisation of the US monetary policy, though it anticipates India is better buffered against likely volatility than in the past. The markets have always been getting closer to a normalization of US monetary policy, though it seems to be an asymptotic curve. In 2013, this would have been an issue, but in 2015, though not insignificant, India is much more buffered in terms of reserves and ammunition to handle any sudden exodus of funds. RBI in stating this point itself seemed comfortable but highlighted the same (for due diligence sake?). 

Notwithstanding the growth as implied by the new GDP prints, the real economy seems to be tottering along at an abysmal rate and inflation is under control, with WPI staying in negative zone for 3 months in a row. Corporate results have been subdued, Passenger car and two-wheeler sales growth are close to zero, and Indian stock markets have been a laggard to regional peers despite improving fundamentals.  There is enough case for RBI to cut rates: repo by 25 bps and CRR by 50 bps in the policy today (though the market consensus is for a 25 bps repo cut and no cut in CRR).

It is time for monetary push to the economy, I say!

Tax Treatment of Debt Mutual Funds - Impact on Yields

In the current year's budget, the finance minister has changed the tax treatment of debt mutual funds considerably.  The following image from Economic Times highlights the changes succinctly:

This change, whether or not retrospective, would in effect kill the product FMP - Fixed Maturity Plans - as the sole selling point of the product was tax efficiency.  As Fixed Deposits become on par with FMPs with respect to tax treatment, the liquidity of FDs will overtake FMPs in popularity. 

The impact on Income funds owing to this tax change would not be as directly comprehensible or not as direct.  As per the latest available AMFI data, total investment of approx. INR 165000 Cr is in non-equity category for periods greater than 1 year. As about 90% of the INR 155000 Cr (after adjusting for Gold ETFs and Overseas Fund of Funds) is invested by Corporates and HNIs, it is fair to assume they are sufficiently tax aware and would be making switches for the proportion of investments they intend to hold less than 3 years. 

It is to be noted that corporates and HNIs look for capital gains (owing to price rises or easing yields) over and above interest income - or in other words, their intended holding period of investment and average maturity of the securities in their portfolio need not match: the former being sufficiently shorter. If there is a portfolio level asset shift is made, then a good amount of longer duration securities could be sold. In a nutshell, this could be sufficiently G-Sec and Corporate bond negative in the short term unless Government/RBI enable FIIs to participate in the market as their limits are now completely utilized and they cannot make incremental investments. MF holding of GSec is about INR 40000 CrINR 8000 Cr (based on total GSec+SDL+Tbill amount of INR 50L Cr and that MFs hold 0.17% of that) (Source: Finance Ministry)out of a total outstanding of close to INR 36 lac Crores. Hence, though the impact on GSec market is negative as some sections of  market currently portrays it to be. However, the major negative impact would be on the NCD and Corporate bond market.

The money that is currently in the liquid funds (approx. INR 1.30L Cr) can find their way to Equity arbitrage funds as the latter is treated on par with equity funds - 15% short term capital gains tax and long term capital gains tax of NIL. More importantly, the definition of long term is only 1 year as against the 3Y now for liquid funds. Whether the Equity arbitrage funds can manage to get the same returns with the increased corpus is a different discussion.

Bottomline of the Tax Revision of Debt MF: 

• Mildly Negative for G- T-Bills
• Negative for G_Secs, Corporate Bonds, CPs,and CDs
• Futures premium over spot in Equity might decline and may not be aligned to call rates in the short term.

Update: If there is a sunset clause to this notification, there could be accelerated redemption leading to sharp sell-off in G-Secs. Keep a look out for the Sunset clause, if indeed it comes bond yields can shoot sharply higher - I expect a barbell kind of a redemption pattern: one bout of redemption immediately on announcement and the second bout of redemption close to the sunset date. Sunset date earlier than 2015 would be significantly negative for G-Secs.

The most important charts from the terrific US jobs report

Interesting Charts on US Jobs Report

MIFOR-OIS Trade of June 2014

Avenues for Indian Financial Institutions to raise USD:

(1)    Direct Fund Raising in Global Markets

(2)    Fund Raising through Synthetic structure

Synthetic Structure Details

In this synthetic structure, they borrow INR in the Indian market at CD rates. They raise INR in any liquid tenors such as 3 Month or 1 Year Certificate of Deposits, reduce the risk of roll-overs by receiving MIBOR and hence immune to local rate swings, Swap the INR to USD at a spread over LIBOR.  The exact structure is that they enter in the market is an INR to USD Float-Float Swap wherein the local Financial institution pays 6M LIBOR+X and receives MIBOR. The synthetic structure would be a better alternative only if the cost is lower than the direct route after adjusting for basis risks.

Risk to the Synthetic Structure

Currency Risk: There is no incremental currency risk owing to the synthetic structure vis-à-vis the direct route as the FI is exposed to INR depreciation against USD equally in both the cases.

Basis Risk: The main basis risk run by the FI is with respect to the spread of CD rates over MIBOR at the times of roll-over. They can overcome this risk if direct 5Y INR money is raised. However, in the current month or in general, there was no major local bond issuance from the FIs/ PSU banks.

Rationale for the Trade

The Spread X would be a function of the difference between MIFOR and OIS levels of corresponding tenures. To arrive at the effective spread over 6M LIBOR, the spread of the bank’s CD over MIBOR needs to be added to X. The following chart highlights the direct USD fund raising rates (red line) versus the derived USD fund raising rates (blue lines). The direct USD fund raising rate is estimated using SBI 5Y CDS spread, US 5Y treasury yield and US 5Y IRS. The derived USD fund raising rate is estimated using spread of OIS over MIFOR and 1Y PSU CD spread over MIBOR.

It can be observed that the funding cost of the synthetic structure is, in general, moderately lower than the direct funding cost – likely attributable to the basis risk. The synthetic USD funding rate was about 6mL + 100 in the beginning of June 2014 and it dipped close to 6mL + 25 in the first week of June – exact time when this trade started to kick in the market. It is to be noted that SBI raised USD 1.25 Bio in April 2014 with close to USD 750 Mio in 5Y tenure at US5YT+205 or equivalently 6mL+185. They went for direct fund raising at 6mL+185 when the synthetic cost was in the similar range (6mL+150 to 6mL+200 in the Jan-Mar qtr); however in June the derived cost was significantly lower (by about 100 bps) and close to the lowest seen in the last 2 years.

A natural question arises as to whether this trade happened in October 2013 – as the difference between synthetic funding and direct funding was larger and that structured funding was happening at sub 6mL+100 levels.An educated guess would  be that October 2013 was a period of RBI firefighting to get in more USD and the said synthetic structure was tantamount to PSU banks buying USD from the local market in a period of local USD scarcity – hence in that window RBI might not have allowed this trade to go through and PSU banks themselves would have found it difficult to garner USD in quantum from the local market. Also, considering the backdrop of 300 bps rate hike and widely fluctuating CD spread over MIBOR, the perceived basis risk would have further prevented PSU banks from the synthetic structure.  Coming back to June 2014, as RBI itself was in the buy-mode in USD, they would have more than encouraged the local/PSU banks to raise USD in the synthetic route absorbing USD from the local market.

The current scenario wherein MIFOR-OIS spread almost touched zero also helped this trade to get highlighted.  Even in Oct 2013, MIFOR-OIS spread was not close to zero with OIS being higher than MIFOR by about 50 bps. Psychological viewpoint of not paying any incremental local fixed rate helped this trade gain traction in the current month. 

As this post is written, the MIFOR-OIS spread is close to zero again. It is likely the MIFOR point acts as a floor for OIS and we are likely to see a reversal in OIS from the current 7.80 level towards 8.00.

RBI Handbook on Weekly Statistical Supplement

I have been a fan of the Reserve Bank of India with respect to the Weekly Statistical Supplement which provides reasonably timely and detailed data on the FX and Money markets in India.

Couple of days back, RBI has released a handbook on the WSS data release which, in their own words, "explains various data items and linkage among different tables which will be helpful in enhancing the understanding of the data."

This should be a good reference point for the FX, Debt and Money market dealers in India.

Link: RBI Handbook on WSS

10Y Yield shooting higher

The 10Y bond seems to have broken its short term trading range of 8.65-8.80 and is currently trading at 8.85. There have been some calls for a 9.20+ levels there.

Technically, as long as we do not close below 8.83, the upside in yields is pretty much open. Come April and a front loaded borrowing calendar (INR 80000 Cr of redemptions in the first 45 days), 10Y yield is looking to stabilize at much higher levels than at present.

Inverted Yield Curve & Investors Aversion to Long Term Securities

G-Sec markets have become extremely sideways in the last one month - starting with the release of Urjit Patel Committee's report. The following chart highlights the same:

Learn About Tableau

Since the beginning of February (despite the Fab start to February), the 10Y bond has been mostly trading in the 8.70-8.80 zone with declining volumes despite the flurry of good news (in CPI & WPI) and slightly incredible news (like the Vote on Account).

At this point, it is interesting to note the below chart on FII debt utilization status:

Learn About Tableau

Three points to ponder:

• FIIs have fully utilized their T-bill quota. This broadly means they cannot bring in money to invest in T-bills when the Tbill issuance is higher than in January and perceived tightness in March. This supply-demand mismatch in short end of the yield curve is likely to keep the short term yields high - close to the MSF rate.
• For domestic investors, with no rate cut in sight, there is immense sense to invest in short end of the yield curve especially when it is inverted. The DIIs should continue to shift away from duration securities to short end of the curve.
• The above two points only suggests that the long term yields are sticky and I find them to be floored at 8.65-8.70 as we gradually move towards the next fiscal calendar.

At this point, as I suggested in my earlier post, the trading range for 10Y bond seems to be 8.65-8.80 for some more time.

Fab Start to Feb for India G-Sec

Continuing from my last post See-saw January for India GSec, the short term target of 8.70% has been already met thanks to INR stability, better than expected spectrum auctions and easing off in global yields.  Though the underlying story of supply-demand is still in place for the current quarter, I do not see large invetor interest coming in to longer term G-Secs. Difficult to see investors taking on duration risk when 10Y yield is at 8.70%(though annualized rate would be 8.89) while 1Y yield is at 8.97% .

This is not to say 10Y yield cannot go below 1Y yield or any shorter term yield, but just that it is possible only when we are in the cusp of a rate cut cycle beginning. With most in the market not calling for a rate cut in the immediate future, an inverted yield curve leaves nothing for investors to continue in the longer duration papers.  To be fair, mutual funds have been consistent sellers in the last fortnight with that section of the market alone selling close to INR 9000 Cr since 20th January. How much of that selling is owing to redemption pressures and how much is owing to fund managers' view on the market remains to be checked with data.

Short term range I see for 10Y G-Sec is 8.65%-8.80%. Range play recommended.

See-saw January for India GSec

India bonds had a see-saw of a January with yields moving from 8.80% to 8.47% and back to 8.87%. Variety of factors contributed to this wild swing:

• Return of FII into the Debt market segment
• The first half of the month saw inflow from FIIs - mostly into the T-Bill segment so much so that they utilized about 90% of their allotted USD 5.5 Billion quota.  We have not seen such high utilization of any segment of the debt market since May 2013.  With T-Bill segment close to the brim, it was only natural for the market to believe any incremental money would have to go to the longer tenor segments.
• Surprises in CPI and WPI prints 
• Both CPI and WPI for the month of December surprised the market on the downside; CPI print came sub 10% at 9.87% - sharply lower than the  11.24% of November. Similarly, WPI saw a downtick of close to 135 bps at 6.16% against prior print of 7.50% and market expectations of close to 7%.
• Cancellation of an Auction
• Along with the renewed FII interest in the new year and the positive momentum set by lower inflation prints, RBI/Government cancelled the G-Sec auction of third week of January triggering a break of 8.70%.
• OMO announcement and Incremental Repo
• As if the bullish momentum set by the FII interest, Lower inflation prints and Auction Cancellation are not enough, RBI announced a surprise OMO which confounded many in the market given that its announcement came just a day before another liquidity infusion announcement via 28 day term repo. This segment of the month can be called the 'exuberant' moments of the month with sections of the market calling for a 8% target for the 10Y benchmark citing the supply-demand dynamics for the quarter. 10Y benchmark touched 8.47% intraday.
• Debt Switch
• The bullish momentum and the exuberance were halted by the announcement of debt switch programme by market 'sources'.  Most market participants did not expect the Government to do debt switch (wherein they buy short term bonds and sell longer term bonds) when the 10-14Y segment of the yield curve is above 9%. With all the bullishness of the month so far, suddenly the debt switch became a credible story which the market believed and began to add caution to their bullish trades.
• Urjit Patel Committee Report
• Next was the release of the much awaited, much dreaded report on changes in the way monetary policy is conducted in India including: CPI targeting, formation of monetary policy committee, Term repo as preferred liquidity tool etc.  This report set the cat among the pigeons as to what could be RBI's intent going ahead. Bond yields saw a retracement of close to 50% of the month's move (back to 8.65-67 levels) as an after-effect of this single report.
• Fragile Five
• EM currencies came under attack with Argentinian Peso, Turkish Lira, South African Rand all seeing a mini-run in the Forex market; this accelerated the FII debt outflow from Indian markets as well. 
• RBI hiking rates
• To top it off the madness of the month, RBI gave the final stroke by hiking rates contrary to market expectations. This completed the bond yields' swing for the month taking it back to where it all started.

Looking ahead: With debt supply coming to an end after next week's auction - the supply demand dynamics should again start getting focus as passive Investors like Insurance companies (LIC has recorded a 32% increase in premium collections this financial year - see Link), Provident Funds will have to buy G-Secs as prudentially stipulated.  The biggest risk to this view would be if the Government announces additional auction.  With a sharp pull back and investor interest close to 8.85% in 10Y as seen on Friday, I would put my bets on long side at 8.80% for a move towards 8.70%. 

The SDL Valuation game

Today's State Development Loans (SDL) saw better than market expected cut-offs in the auction (Auction results page): with yields in the range of 9.35%-9.40%. If an investor (read: banks / Mutual Funds) has bought the SDLs in auction today, they would get a valuation gain of close 27-30 bps owing to weird valuation mechanisms followed in India.

As per FIMMDA valuation guidelines, SDLs are valued at 25 bps spread over corresponding G-Sec. Though INR 8000 Cr of SDLs are sold in auction today - the auction cut-off prices are not used for valuation but spread over GoI 8.83% 2023 security is used. As an illustration, if an MF/bank has bought 10Y Tamilnadu paper at 9.41% yield, it can instantly show a gain of 9.41% MINUS (8.83%+0.25%) of 33 bps or equivalently close to 2.31% overvaluation.

With the current quarter being pathetically bad for most fixed income investors (read: banks) they might tend to use such 'valuation' gains to hide real losses in their bond portfolio. In times when most global regulators are seeking more transparency, it is a sham(e) India still continues to have such not-so-above-the-table valuation practices.

Expectations from Revised Monetary Policy Framework

RBI Governor, Raghuram Rajan, during his much celebrated September 4 market interaction informed about the formation of a committee under Deputy Governor, Urjit Patel, for proposing changes to the existing monetary policy framework.  This revised framework was expected to be released in 3 months time.

Since 3 months have since elapsed, market speculation about the likely release of the new framework has kept the Indian rates market under check with extremely reduced duration risk appetite and trading volumes.

The key outcome of this revised framework could be

• The new 'inflation' anchor to the monetary policy rates. Currently, RBI uses the WPI as the main policy anchor with a 'comfort' level (not a target) of 5%; must admit RBI also looks at Core WPI and CPI amongst other inflation measures.  
• Preferred liquidity management tool: OMO or Term Repos?

Inflation Anchor
In the new framework, RBI might shift the inflation anchor - following are the options:
WPI to CPI
This is a shift which will make Indian inflation numbers comparable with the rest of the world; simple for not-so-sophisticated portfolio investors to look at 'real' yields across countries. The main drawback of the CPI measure is its volatility - with food having close to 48% weightage in the index, the headline CPI is subject to swings based on seasonality or frictional factors impacting food.  Setting policy rates on a volatile index is definitely undesirable.

WPI to Core CPI
On more than one occasion, Raghuram Rajan has cited the trends / levels of Core CPI as one of the reference point for the monetary policy decision.  With core CPI actually reflecting household inflationary expectations, I expect this to be the likely choice of inflation anchor for RBI.  There are some calls by research houses that RBI might choose Core CPI minus Housing as housing has not shown interest rate sensitivity in the last 5 years: but, in my opinion, over a longer observation period, real estate and housing are definitely sensitive to interest rates and the complete Core CPI should become the monetary policy's preferred inflation anchor.

Liquidity Management: This would be of particular relevance to bond traders and mutual fund managers. Till the introduction of term repos, RBI typically uses purchases in Open market operations (OMO) to infuse liquidity into the banking system. OMOs had been used even for frictional liquidity stresses like advance tax outflow windows. But with term repos, the requirement for OMOs have somewhat been reduced. RBI had been looking at OMOs only if liquidity stresses were seen to be longer than just being frictional - say stress for 2-3 months. If term repos are extended beyond 14 day tenure to 30 day / 60 day tenures, the need for OMOs would be drastically reduced. OMOs would then be used only in times of primary liquidity withdrawal like USD sales or lack of growth in M0 is hampering credit offtake.

Indian yield watchers are keenly tracking this. Shift to Core CPI as inflation anchor and employment of longer tenure repos are likely to be bond negative.  Are we taking the new 10Y benchmark to 9+ yield levels?

CPI linked IINSS - not attractive at all

CPI linked securities were touted by RBI and Finance ministry to be the main answer to counter the ‘menace’ of gold buying by Indian citizens. Here is how the new product offered by RBI stacks up against the yellow metal.

Investible Limit

IINSS: Minimum lot size is INR 5000 and maximum is INR 5 lacs per annum. The upper cap on the investment baffles me.

Gold or Gold ETF: Minimum lot size is 1 unit of the ETF which typically is 1 gram equivalent. Maximum is generally not capped unless some AMC suddenly acts to be patriotic and limit future investment in the ETF.

Result: Gold is better than IINSS as there are no restrictions on the minimum or maximum lot sizes.

Lock-in and Liquidity

IINSS: 3 years for general public and that too after a penalty of 50% of last coupon – additionally can be done only on the coupon date.  Even the WPI linked bonds are much saner in this aspect as they allow selling any time post the purchase.

Gold: No Lock-in whatsoever.

Result: Gold is better than IINSS as there is practically no lock-in and liquidity is proven.

Tax Treatment

This is the most crucial aspect which totally baffles me as to what the IINSS product designers were thinking.

IINSS: The coupon is fully taxed at the investor’s marginal tax rate. As per the specification of this product, the interest is accrued semiannually but paid out at the maturity after 10 years.  But the investor has to show the interest each year and provide for tax. The retail investor can’t arrive at the coupon received on checking his bank statements and pay tax, but has to ‘compute’ the interest earned using an Index which the RBI itself has declared to be not yet stable. The investor has to compute interest on a complex index, calculate tax (no TDS) based on his marginal income tax rate and pay income tax on an interest payment he has not received - not going to receive in the next 10 years.  The net negative cash flows owing tax payments can easily outdo the 1.5% yield premium provided. Outrageously bad.

Gold: The investor can ‘generate’ a coupon by selling the units of ETF. Short term capital gains tax are the investor’s marginal tax rate – effectively same as IINSS. Long term capital gains tax (>1 year) is after application of indexation benefits: 10% without indexation and 20% with indexation. The best part is the indexation itself is based on CPI.

Result: IINSS is particularly worse in this regard with the issuer (who is also the tax collector) having the cake and eating it too. IINSS is probably the only financial product in the country which has a lock-in period without any tax benefit either at investment or at income stage.

Overall Verdict: If you are patriotic and want to donate money for the nation’s welfare, IINSS would be more profitable than giving money directly to PM fund. The main declared objective of IINSS was to shift investments from gold to IINSS – I expect that wont happen one bit.

On a serious note, IINSS is definitely inferior to Gold ETF on a variety of factors as listed above – only solace for IINSS is it can’t have negative return while Gold can have negative returns – that is true for any fixed income investment vs risk asset investment; even tax free bonds issued by PSU companies offer more value than IINSS; WPI linked bonds offer better value than even tax free bonds because of the low coupon and better effective tax treatment; easiest of all – even debt mutual funds offer more value than IINSS because of the tax angle.The only product that IINSS can possibly beat is bank fixed deposits - even FDs have some tax benefits when booked for 5 year tenure.

Bottomline: I will stick to WPI linked bonds than to invest in IINSS if I want to be anchored to a local inflation index.


Suggestions to RBI/Government of India: 
A flat income tax rate of 10% on the coupon + option of taking out coupons semiannually could make the product sufficiently attractive. 

Is Indian Debt Market closer to Global Bond Index Inclusion?

All markets have been fearing the impact of likely US Taper, likely announcement to happen over this week with cut backs to start as early as January.  Interestingly, Indian bond markets have seen sharp inflows in the last one week, despite the slew of good economic data in US. Tbills and dated securities have been bought by FIIs to the extent of INR 2000 Cr each, intense buying post the CPI data. 

Most of the dated securities buying has been by the Longer term investors (like Sovereign wealth funds, Pension funds, Insurance funds etc.). Buying of Tbill at the current USDINR forward levels suggest the FIIs' comfort on USDINR spot as well - as they can't be hedging when the forward levels are so high (8.25%+LIBOR).

Are we closer to bond index inclusion than what the local markets believe?

Source of Data: NSDL

Must Read article for India Fiscal watchers

This article is a must-read for fiscal watchers. Seeing through the fiscal math with reasonable 'comparable' numbers - India is heading towards a fiscal cliff.  I have not done the checking of the figures here, assume Business Standard would have already done it.

Link from Business Standard

New 10Y bond heading to 9% handle

The Economics affairs secretary just made a press statement that Indian Government will conduct the much feared "Debt-Switch" programme in the market and not with RBI as was previously expected by the market considering the high yield levels.

This practically means INR 50000 Cr of debt supply to the market at a time when there is little interest in the secondary market; even PFs are opting for the yield pick-up from Corporate bonds and State Development loans post the recent change in investment pattern norms.

Even if Government buys back G-Secs maturing in 2015, 2016 and 2017 and issues, say, 15Y papers, the net duration in the market is going to raise sharply. All set for 9% mark even in the new 10Y bond in few trading sessions from now.


Reuters link

IFC Rupee Bond success

IFC issued INR 1000 Cr of bonds to global investors which has been lapped up happily by foreign investors. For starters, it is a 3 year bond which got issued at coupon of 7.75%. The money collected by IFC will be invested into Indian companies and the investors take the currency risk. It leads to the question what are the foreign investors trying to tell us with the cut-off for the bond issue.

This leads to a direct question of why the coupon has been fixed at 7.75% not close to 9.25% where current 3Y corporate issues (AAA) should be trading at - as the currency risk is with the investors. 

As per my understanding, the intermediation of IFC is taking care of two main risks for which the investors are sacrificing close to 150 bps of yield pick-up despite taking on currency risk on INR:
1. Credit Risk: Even if the Indian corporates to whom IFC lends money defaults, the investors will still get back the money in INR terms. It is to be noted that IFC is AAA rated in $ terms.
2. Convertibility risk: Investors are assured of dollars at the end of 3 years; they are exposed to capital gain / loss depending on INR spot levels but they need the assurance of getting the dollars at the end of three years. Without IFC mediation, they could end up not being able to convert the INR into dollars - sounds like a risk India might totally stop outflows if things go further wrong from here.

Just for the record,US Treasuries for 3Y are at 0.60%; 5y BBB- (India rating) spread is close to 300 bps. Hence, India's dollar yield should be close to 3.60% for 3 years. For corporates, there would be a further spread of 60-70 bps taking the Corporate yield in dollar terms to 4.30%.  With INR yield of corporates trading at 9.30%, the IFC issue of 7.75% suggests foreign investors are pricing in the credit risk of AAA Indian corporates and Convertibility of INR to USD at 155 bps. 

Business Standard Link

10Y yield above 9% - Investors to come in next?

There have been quite a few calls on TV in the last couple of days about shifting of assets from Equities to Debt. It is not counter intuitive given the fact 10Y GoI Security had found itself only few times above 9% in the last 10 years. Though past data could be insufficient to explain future price action, it need not be completely ignored.

Following is the histogram of 10Y yield on closing basis:

  

With Current 10Y yield at 9.05% (1.4% event in last 10Y), it is only natural to see longer term investors coming into the market. Hopefully.

Inflation Indexed Bonds better than Tax Free Bonds

10Y inflation indexed bond issued by Government of India is giving a real yield of 3.47% - at WPI expectation of 6% it gives an IRR of 9.96% which is significantly better than the IRR of 8.70% for 7.16% 2023 bond which is the current 10Y.  The IRR of the bond at various WPI expectations are as per the following table:

Average WPI expectation for next 10Y	IRR of the 10Y Inflation Linker at CMP
4%	7.68%
5%	8.74%
6%	9.80%
7%	10.87%
8%	11.95%

The key item of note in this case is the low coupons of the bond – it can be considered a zero coupon bond with little reinvestment risk; add to that the long term capital gains on maturity will have indexation benefit as well and hence materially tax efficient. 

To summarize, Inflation Indexed Bonds:

•  Have Less Reinvestment Risk
• Are a good hedge against WPI increases, especially in a period when imported inflation is a genuine reality
• Have Low Coupons meaning lower tax on coupons (slightly redundant to cite, I agree)
• Are Tax efficient on capital gains as Indexation benefits get applied

Leave all the tax free bonds and buy this sovereign rated Inflation Linker.

Good way to buy GSec for Retail investors who do not hold CSGL accounts IDBI Samriddhi Portal

Update: I have made this post sometime in August and now Foreign institutions are queueing up in advising institutional clients to get into IIBs. Please find the link here of the report from Barclays.

Updates:
Why WPI IIB is better than CPI IINSS?
Indexation benefits of WPI IIB 

RBI: Money market rates and Rupee Defence

Having the benefit of a late response: RBI followed up the Jul 15 measure with further tightening this week: restricting the LAF borrowing by banks to 0.5% of the banks' individual NDTL - this does two things:

(1) Restrict overall LAF borrowing max at 35k Crs
(2) Making funding of excess SLR by banks and Primary dealers expensive and/or uncertain.

The excess SLR holding of banks is close to INR 4 lac Crores and that entire portfolio's funding cost can now swing between 7.25-10.25 which effectively means banks with excess SLR will not venture into adding to their portfolios at this point: good illustration is yesterday's and today's Tbill cutoffs of >11%, last week's devolvement og G-Sec auctionand likely devolvement this week as well. The yield curve could remain inverted till the measures are reversed and markets clearly perceive that inflation & currency risks are addressed and that the focus of RBI will shift towards growth. With the impact of the fresh reporting fortnight kicking in from next week, the movement in overnight rates could be interesting - one solace would the Govt's month end spending.

To see the impact of the RBI measures to FX market: the Forward premia and MIFOR levels have shot up in line with other rates curves effectively making it prohibitively expensive for anyone to buy forward dollars. This means different things for different players:
(1) If FII flows do come into debt, these would have to be unhedged by the sheer unattractiveness of the hedge - meaning RBI is directly signaling the long term players amidst FIIs like Pension funds, Sovereign wealth funds are welcome and not the arbitrageurs (aka hot money) playing the interest rate differentials.
(2) With an explicit support to INR spot, exporters still can forward sell their dollars at almost the same levels as in the 2nd/3rd weeks of July (despite the 90p downmove since Jul 15). This effectively encourages exporters to hedge and importers not to hedge.

From behavioural front, the sheer pain of most banks in their bond books would make them speculate much less in FX. After all, quarterly results and NIMs matter. 

Going forward, I would be keenly tracking how much redemption pressures come to Debt mutual funds. If that turns out to be material, along with the relentless supply till end August and queasy funding costs, yields can head higher even from these levels - we are already in uncharted zone in this currency cycle. On my personal HTM portfolio, I would put more money in debt funds than in equity funds at this point.

At the risk of being an hyperbole, money markets have got a step-motherly treatment to bring some stability to the favoured FX spot. All said and done, INR Spot will remain the cynosure of the central bank in the near term