This column was written by Santosh Kamath. MD- Local Asset Management, Fixed Income, Franklin Templeton Investments, for the India Markets Observer.
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 cut policy rates in mid-January 2015, ahead of its scheduled 3rd February, 2015 policy meet. It also indicated a shift in monetary policy stance, and said that further easing would depend on data that confirms continuing disinflationary pressures, high-quality fiscal consolidation, and steps taken to overcome supply constraints. The fiscal deficit situation has also improved, and although we might not be entirely out of the woods, it is unlikely that we will miss the 4.1% budgeted fiscal deficit target for FY15 by a very wide margin. 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 market 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 FY15, which has helped expand the investment horizon for debt products, and thereby reduce liquidity pressures to some extent.
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 U.S. economy, which expanded by an upwardly revised 5% during the third quarter of calendar year 2014, on the back of a 4.6% GDP growth registered in the second quarter. This raised hopes of a rate hike, and the U.S. Federal Reserve recently removed from its December policy meeting statement the phrase that it would wait a “considerable time” before starting to raise rates, although it added that it will be “patient” on interest rate timing.
The recovery prospects has also helped the U.S. dollar continue to garner strength, with the U.S. dollar index finally ending the year 2014 with a healthy gain of close to 13%. Firming up of the dollar and prospects of a rate hike could result in some flight of capital flows back to the U.S.—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 once again play a bit of a spoiler to the Indian bond market 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 calendar year 2014. This was after a net outflow of around $8 billion registered in calendar year 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. The 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 the demand of funds, had fallen in FY14 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 upcoming Union Budget, it would be worthy to note whether the government sticks to the fiscal deficit consolidation roadmap outlined in the Fiscal Responsibility and Budget Management Act, or FRBM. Any upward revision to the fiscal deficit targets may not be taken well by the bond markets.
To conclude, 2015 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.
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