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On July 15, when the Reserve Bank of India raised short-term interest rates by 200 basis points, it sent shockwaves through the bond market. Liquid funds which are considered safest investments for investors posted negative returns for the first time.
As liquid funds had to value their holdings to the market rate, their net asset values took a hit. Fund managers knew that this was a one-off blip. But investors were anxious. From early morning to late evening, R Sivakumar, head of fixed income of Axis Mutual Fund, worked the phone trying to convince investors to stay put. Nevertheless, about Rs 45,300 crore worth of investments were pulled out from liquid funds in July.
Such times have never been seen before in the bond market. Fixed-income managers have been on the edge of their seats the past three months as every other day, a fresh regulation from RBI brings a new set of challenges for their portfolios. "There is constantly something new happening. Every evening, we talk to other fund managers and try to anticipate what RBI's next move would be, and how it would impact the bond market," says Sivakumar.
Taking a new turn
Fixed-income funds account for over three-fourths of the assets under management in the mutual fund sector. Devoid of wild swings, the asset class has always been considered a safe bet by investors. Still, in the last few months, fund managers have seen most of their calls go haywire. How did the market change its direction?
Late in 2012, Amandeep Chopra was convinced that good days were ahead for bond investors as he expected RBI to start cutting rates to kick-start the weak economy. The head of fixed income at UTI Mutual Fund began a series of presentations to persuade potential investors to take a fresh look at the bond market, and take a shine to bond funds in particular.
For his part, Chopra started to swap short-duration holdings for longer-duration ones. Others such as Dhawal Dalal, head of fixed income of DSP Blackrock, and Sivakumar thought that RBI would cut rates and so fortified their bond holdings for a rate cut. By increasing the average maturity of his holdings, a fund manager increases the chances of gaining from bond-price increases when rates are cut.
The strategy helped bond fund managers reap rich dividends as RBI cut rates by a 25 basis points in January and followed it up with more rate cuts in the ensuing months.
"We told investors to start making bonds a decent part of their portfolios. The rate cut in January reinforced the dovish outlook and we convinced investors to buy more bond funds," says Chopra.
Chopra bought bonds across funds and increased the average maturity of his funds, some with maturity period extending up to 10 years. The idea was to lock in at higher rates and also have more long-duration bonds in his portfolio. This positioned him to make the most of a rate cut.
As anticipated, rates started falling, causing the value of long-term bonds to rise. The longer the maturity period of a bond, the more it soars in value. Fund managers like Chopra couldn't be happier. Long-term bond funds topped 14 per cent in returns by the end of May, while others were returning 12-13 per cent.
But despite the exuberance of his fellow fund managers, a niggling doubt kept worrying Dalal of DSP BlackRock Mutual Fund: "Why was the rate cut not being transmitted through to the economy?" RBI had cut rates thrice already - by 75 basis points in 2013. But banks were unwilling to pass on the lower rates to customers. This was so because depositors were not parking their money in banks. With not much cash coming to them, banks had little scope to lower lending rates. For Dalal, this sowed a doubt-were the rate cuts sustainable?
It turned out he was right. Few fund managers were prepared for the meltdown in bond markets that hit in May. US Fed Chairman Ben Bernanke spooked the forex and bond markets with his talk of tapering down the amount spent on Quantitative Easing (QE). Global bond and forex markets were roiled by the immense selling of bonds that ensued. Foreign investors, who for a long time were playing the arbitrage game by borrowing in dollars and investing in rupees, started pulling out from Indian bonds and the Indian currency. Bond yields started soaring as fund managers dumped bonds. Managers who were sitting on longer-duration bonds started to see red splashed over their portfolios.
While domestic investors were still trying to make sense of what was happening, Dalal felt that RBI would focus on the rupee and that bond markets would turn volatile. In a note to investors early in June, he said that whenever there's turmoil in the currency market, RBI focuses on the rupee-and the rate cuts that everyone expects might not materialise.
"From there on, we started cutting the average maturity of our portfolios. We realised that if outflows from emerging markets continued, the currency would depreciate and bond yields would surge," he says.
Bigger trouble
But the worst was yet to come. Foreign investors were dumping bonds at an alarming pace. They sold bonds worth nearly Rs 39,000 crore between June and August. The 10-year benchmark yield started to soar near 8 per cent that was seen at the beginning of 2013 when bond funds were positioned for a rate cut. The bond market started getting more volatile.
On 14 August, RBI restricted foreign-exchange controls on Indian individuals to $75,000 a year (from $200,000 earlier), and on Indian corporations to 100 per cent of their net worth. The rupee hit 65 against the dollar on 16 August as foreign institutional investors saw the moves as restricting their investments. Bond yields shot through the roof to nearly 9.4 per cent, and most fund managers were losing the plot.
Dalal, meanwhile, had started reducing risks and increasing cash positions since June so that his portfolios could withstand the stress of the eventual hardening of rates. "We realised that the risk-reward ratio was not in favour of the investor. The bulk of the longer-duration assets was sold off and we brought down our maturities to around 1.5 years," he says.
But finding buyers was getting increasingly difficult. The supply of bond papers had suddenly surged and dealers had to struggle to trade them. Those who reduced their holdings managed to cut their losses. As a result, some bond-fund managers are now sitting on about 15-20 per cent cash equivalents in their portfolio, with the rest in shorter-duration bonds of about a year or two.
Managers know they will be better off erring on the side of caution. With RBI still not done with its policy calibration and the rupee still volatile, for bond fund managers, the last three months have brought extreme conditions, one they hope they will never see again. "The rupee (depreciation) had a severe impact on the bond market. I have never seen such volatility before," says Sivakumar.
While managers have drastically reduced their risks, they still see some volatility. Yields on corporate bonds have shot up to around 10.5 per cent, but liquidity is low. All eyes are on the US Fed meeting this month where a QE tapering plan is expected to be released. Says Dalal: "This is not the time to take aggressive risk on yields or go heavy on bond investments and lengthen durations." Bond fund managers are, indeed, playing it safe.
R Sivakumar
Head of Fixed Income, Axis MF
* Exited bond positions in May and early June after yields soared and bond prices fell
* Has been buying since August as the yields have increased to attractive levels
* Has maintained a high quality of bond portfolios with more liquid assets
Amandeep S Chopra
Group president and head fixed income, UTI MF
* Took a call to go long on bonds and increased the average maturity of his funds early in the year
* His funds were among a handful of liquid funds that were not severely impacted during the crisis
* He has reduced the duration of his funds now to 5-6 years to take advantage of the higher rates
Dhawal Dalal
Executive Vice-President and Head-Fixed Income, DSP Blackrock
* Outlined the risks of bond funds to investors in early June as RBI was increasing focus on managing the rupee
* The US Fed's plans to slow down Quantitative Easing was a trigger to reduce his heavy fixed-income portfolio in favour of a more liquid portfolio
* Has cash and cash equivalents of around 20 per cent in many funds
