Santosh Kamath, Managing Director - Local Asset Management, Fixed Income, Franklin Templeton Investments, India
The year 2014 ended on a good note for Indian fixed-income markets, with bond yields softening considerably, especially in the second half of the calendar year. The three key risks for fixed-income funds (interest rate risk, credit risk and liquidity risk) now appear to be more benign or manageable in India.
The interest rate risk has reduced with both inflation and inflationary expectations moderating considerably from their earlier highs. The RBI has changed its monetary policy stance, and gone in for two inter-meeting rate cuts so far this year. It also added that further monetary action would depend on data, fiscal consolidation, pass-through of rate cuts, monsoon and global developments. The fiscal deficit situation has also improved, with the government saying that it will meet its budgeted fiscal deficit of 4.1 per cent of GDP in 2014/15, although it extended the timeline to achieve the fiscal deficit target of 3 per cent by one year (to 2017/18). The sharp fall in crude oil prices has been a boon for oil importing countries like India, and may help to improve our current account balance and keep inflation in check.
The credit risk too has reduced, with the local credit environment improving, as suggested by improving credit ratio (number of upgrades to downgrades). With the equity markets also faring well, companies are now finding it easier to raise capital through other means, and thereby reduce their leverage or debt component. Liquidity risk is also limited, due to taxation changes for debt-oriented funds announced earlier in Union Budget 2014/15, which has helped to expand the investment horizon for debt products, and thereby reduce liquidity pressures to some extent.
However, that being said, there are some key factors that investors need to be careful of in 2015 with respect to the fixed-income markets. One key risk is the recovery and strength in the US economy and also improvement in jobs data. This has raised hopes of a rate hike, and the US Federal Reserve has dropped the word 'patient' from its forward guidance, but at the same time mentioned in its recent statement that even though inflation and employment are near mandate-consistent levels, economic conditions may for some time warrant keeping the target fed funds rate below levels the committee views as normal in the longer run. The recovery prospects have also helped the US dollar to continue garnering strength, with the US dollar index ending the year 2014 with a healthy gain of close to 13 per cent, and with the gains continuing so far in 2015 as well.
Firming up of the dollar and prospects of a rate hike could result in some flight of capital flows back to the US-thereby putting pressure on emerging market currencies, including the Indian rupee. Although the rupee has depreciated a bit recently, it has performed relatively better than most other emerging market currencies in 2014, especially the 'fragile five'. The currency stands relatively better placed than in mid-2013, but is still susceptible to some volatility, in the event of a Fed rate hike. This could one again play a bit of a spoiler to the Indian bond markets and put pressure on bond yields in the short term, although the impact is unlikely to be as adverse as in the latter half of 2013.
The second key risk that looms is any intermittent disruption in foreign inflows. The Indian fixed-income market has been the recipient of record foreign portfolio inflows to the tune of around a net $26 billion in 2014. This was after a net outflow of around $8 billion registered in 2013, as a result of Fed taper concerns. Considering the copious volume of foreign inflows in 2014, any disruption or reversal of flows in the short term can once again lead to volatility in the bond markets, and put pressure on the currency as well. As mentioned earlier, a sharp fall in crude oil prices will be a positive for oil importing countries like India. However, at the same time, if crude prices continue to remain depressed, then it may impact liquidity or flows from oil exporting or producing countries, thereby squeezing foreign portfolio flows into the Indian markets to some extent.
Another factor to look out for is the savings-investment gap (see chart below). Domestic savings rate, which denotes the supply of funds through domestic sources, has shown a falling trend in the last couple of years. The investment rate, which denotes demand for funds, had fallen in 2013/14 due to a slowdown in the economy. However, with the economy now showing signs of a pick-up, any significant rise in the investment rate may put pressure on interest rates. Lastly, in the Union Budget, the government pushed back its fiscal deficit target of 3 per cent by a year (to 201718), providing some flexibility to fund infrastructure investment. Any further pushback will not be taken well by the bond markets.
To conclude, 2015 has started on a good note with the central bank shifting its monetary policy stance and easing policy rates. Expectations and market chatter of a secular downtrend in interest rates has increased in recent months. However, it may be prudent to also take cognizance of the earlier highlighted risks that still prevail, and be watchful of how developments shape up on these factors, going forward.
(The author is Managing Director - Local Asset Management, Fixed Income, Franklin Templeton Investments, India)