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Business News/ Opinion / Let Raghuram Rajan manage your bond returns
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Let Raghuram Rajan manage your bond returns

Current regime is providing a strong opportunity to earn relatively more stable positive real yields

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Traditional wisdom links bond investing to expectations of rate cuts by the central bank. Rate cuts drive down bond yields and, correspondingly, drive up bond prices. This leads to capital gains for bond investors. The central bank obviously plays a large role in setting the rate expectations of the market, but these expectations depend upon a variety of factors—the central bank’s guidance for the future; the emphasis, or the lack of it, on a specifically defined policy framework; and even the past reaction to monetary policy setting.

Over the first half of 2013, the Reserve Bank of India (RBI) cut repo rate by 75 basis points (bps; one bps is one-hundredth of a percentage point) to 7.25%, thus fuelling a massive bond rally and generating aggressive expectations of more to come. It may now sound somewhat surprising but when the first rate cut of this period was announced, the Consumer Price Index (CPI) inflation was still close to 11% and did not fall below 9% throughout this period when the 75 bps of rate cuts were administered. And yet, when these cuts were actually happening, they were very much along expected lines.

Not just that, expectations of future cuts remained very much alive even though the RBI’s own forward guidance had turned conservative by then. This happened largely because the RBI’s policy framework at the time was following a ‘multiple indicators’ approach. Within inflation, the dominant policy variable was the Wholesale Price Index (WPI) and not CPI. And, there were no explicit ‘targets’ even with respect to WPI. Therefore, as WPI began coming off, market expectation began running ahead even of RBI’s own forward guidance. Then the US Federal Reserve’s taper fears struck with consequently extremely painful adjustment both to RBI policy rates and bond returns.

In January 2014, the RBI unveiled a new framework with the Urjit Patel Committee Report. The anchor for monetary policy was shifted to CPI inflation with explicit ‘targets’ of 8% and 6% for years 1 and 2, respectively. Thus, even though multiple macroeconomic indicators such as current account deficit, fiscal deficit, and inflation have shown strong and sustained improvements over the past few months, markets haven’t priced in aggressive interest rate cut expectations. In fact, bond yields have spiked after the last monetary policy review earlier this month largely because market participants have been reminded that CPI falling below 8% is not enough and that the RBI is equally serious about its year 2 target of 6%.

Returns beating inflation

First principles first. Investments in fixed income create income, not wealth. And the predominant desire that a saver has, whether intuitively or explicitly, is for income to beat inflation, i.e., savings should earn positive real returns. If the concept sounds theoretical, it shouldn’t. Inflation-indexed bonds exist for this reason. Household budgets are dented or made partly for this reason. And finally, even the seasoned bond investor, at least intuitively, buys bonds for this reason: it is not for nothing that the single largest longer term driver of bond yields worldwide is inflation.

The chart tracks a proxy for ‘real yield’ calculated as the difference between 10-year government bond yield and CPI inflation. As can be seen, real yield has been negative for most of the past five years. It was aggressively so till most of 2010. However, over the past six months or so it has turned positive as the process of sustained disinflation appears to have gained traction since the last quarter of 2013.

The past two years’ fiscal consolidation as well as rationalization of minimum support prices (MSPs) since last year have no doubt contributed to this process. The same intents on fiscal consolidation and lower MSP settings have been carried forward by the new government. Additional steps are also being undertaken to arrest volatility in food inflation. These, alongside the RBI’s explicit monetary policy framework targeting lower CPI inflation, are suggesting a much greater confidence with respect to lower average inflation over the next 3–5 years than has ever been the case in recent history. Put another way, there is much greater confidence now that bond investors will be able to earn positive real yield over the next few years.

If investors agree with this view point, then this is the biggest reason to invest in bond funds today; not when the RBI will be able to cut rates. In the previous multiple-indicators monetary policy framework where WPI was the dominant inflation variable, repo rate would already likely be lower by now. This would have caused bonds to rally and thereby provide immediate gratification to investors. However, by definition, the cycle would have been shorter and, correspondingly, future real returns would have turned volatile. Instead the current regime is providing a strong opportunity to earn relatively more stable positive real yields in the years ahead.

Obviously, distribution of returns will still have some volatility depending upon expected and actual path of future policy action. However, given the stability and focus of the RBI’s framework and with every reason to expect complementary action from the government, perhaps for the first time in five years, there is now a fundamental reason to buy bond funds. And the reason is not an early expected rate cut but the fact that the RBI is almost insistent on providing real, sustainable and positive returns to long-term bond holders.

Suyash Choudhary is head, fixed income, IDFC Asset Management Co. Ltd.

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Published: 21 Aug 2014, 06:23 PM IST
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