Get over that monsoon obsession. For India’s best-performing fixed-income fund manager, a potential increase in U.S. interest rates is a bigger risk for local bonds.
To prepare for it, Santosh Kamath of Franklin Templeton Asset Management India Pvt. is boosting holdings of corporate notes rated lower than AAA that he says will be shielded from capital outflows when the Federal Reserve tightens policy given their small foreign ownership. Lower supply of the debt, relative to sovereign securities, is also adding to its appeal for Kamath, the money manager’s Mumbai-based chief investment officer for fixed income.
“The external environment to my mind is a bigger fear than the monsoon,” Kamath said in a July 3 interview. “We have seen U.S. government-bond yields move higher even without the Fed’s action and that may have implications for India. It is one factor that we should give more weightage to now than earlier.”
Five-year Indian sovereign yields jumped the most in almost two years last quarter as the Fed signaled it’s on track to lift borrowing costs this year and the crisis in Greece deepened. The advance in yields on similar-maturity AAA-rated company bonds and AA notes was much smaller. The Indian weather bureau’s forecast for below-average monsoon rains also spurred concern damaged crops will stoke food costs.
“There’s limited foreign holding in the sub-AAA segment, so even if foreign institutional investors want to re-allocate their capital, they will be selling government securities or AAA bonds,” said Kamath. “Although there’s no published data, market sources indicate that about four-fifths of global funds’ Indian debt holdings are in sovereign and AAA-rated notes.”
The extra yield 10-year Indian sovereign securities offer over similar-maturity U.S. Treasuries reached 534 basis points on June 10, the smallest in two years.
The Franklin India Dynamic Accrual fund, co-managed by Kamath, has returned 5.3 percent, the best returns this year in the category of fixed-income funds with an equivalent of at least $100 million in assets, according to New Delhi-based Value Research India Pvt., which tracks mutual funds.
Investments in debt rated AA and below made up 80 percent of the fund’s assets of 11.5 billion rupees at the end of May. That compares with a peer-group average of about 66 percent, Value Research data shows. Top-rated notes formed just about 7 percent of the Franklin fund’s corpus, a fourth of the average for peers.
Five-year sovereign yields jumped 32 basis points last quarter amid a global selloff in bonds. Similar-maturity AAA corporate yields rose 13 basis points while those on AA debt gained just four basis points.
Increased volatility in the bond market is making companies reluctant to borrow for longer tenures. Local firms’ issuance of notes maturing beyond five years slumped about 80 percent last quarter, data compiled by Bloomberg show.
A reduction in companies’ working-capital requirements amid a demand slowdown in Asia’s third-largest economy has contributed to a decline in fresh issuance, another reason Kamath cited for his bullish stance.
“Unlike the government of India, which does the primary supply every week, most of the corporate-bond supply is to raise money to refinance and pay the banks off,” he said. “Whenever the supply of paper is less, the spreads of those companies will keep coming down.”
Five-year AA bonds yield 9.11 percent, 115 basis points more than similar-maturity sovereign rates, data compiled by Bloomberg show. The spread reached as high as 149 basis points in January.
Prime Minister Narendra Modi’s government aims to borrow a gross 6 trillion rupees in the year ending March 2016.
Reserve Bank of India Governor Raghuram Rajan flagged deficient rains, rising oil prices and external volatility as inflation risks as he cut the repurchase rate for the third time this year on June 2. The June-September monsoon showers are forecast to be 88 percent of a 50-year average this year, threatening to stoke food costs, which account for almost 50 percent of the consumer-price basket.
Inflation quickened to 5.01 percent in May from this year’s low of 4.87 percent in April, official figures show. Economists dumped their predictions for a cut in the benchmark interest rate by March, with the central bank now seen holding it steady at 7.25 percent through at least June, according to median estimates in the latest Bloomberg survey.
Rajan last month warned of more volatility in global financial markets on par with the so-called “taper tantrum” in 2013 that had seen global funds pull out about $9 billion from Indian government and corporate notes in the June-August period after the Fed indicated it would end its bond-buying program.
“The external volatility is a bigger risk, which may surface and prompt the RBI to be in a pause mode for the next three to six months,” said Kamath. “We can still manage inflation with supply-side measures but we don’t have much control to deal with external volatility.”