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Debt Market Weakness: Why This Might Be an Opportunity?

 

February was a tough month for our All Weather Fixed Income Portfolio in the midst of a dismal bond market performance. However, we believe that it was a very attractive opportunity for the clients to increase an exposure in fixed income.

The RBI did not ease repo rate by 25 bps as widely anticipated and the bond market sold-off 10 year futures by almost 5% from its high. This led to the longer maturity part of the portfolio, giving back all its excess gain from the last 2 months.

At the end of January, we were comfortably beating the benchmark by almost 3%. The sell-off in the longer maturity portion of the portfolio reversed this outperformance.

Before we go any further, let us understand a few things about our fixed income portfolio and fixed income in general.

Our fixed income portfolio is no different than a well-diversified equity portfolio with exposure to individual sectors in fixed income that aggregates to form a well-diversified fixed income portfolio. In equity market parlance, it is as if one sector has really underperformed for the time being, leading to a broader market weakness. As past data indicates, the portfolio outperforms the benchmark by 2% or more on an average. There are years like 2011 and 2013 where the portfolio underperformed by 0.5-1%. These years are not exceptional and can certainly occur in the face of continued bond market weakness. Our portfolio construction accounts for it and is constructed to deliver the best result over time, irrespective of the performance of a sector within it. This does not mean that it will go up every day – it will go up on an average over time. If it was to go up every day, then there would have been no reason for the portfolio to deliver the excess return over fixed deposit. One should realize that the banks do the same – they take depositors’ money and either loan them out or invest in similar fixed income securities. In return for providing a “seemingly safe” fixed deposit, they take the risk and pocket the extra 2% to 3% over time.

Now, do we expect this bond market weakness to persist? We believe it will not for a sustained period of time. India cannot have high credit costs and expect to grow at 7% – 8% as envisioned by the Government and RBI. But can it last for the next few months and we do not end up outperforming our benchmark this year? Yes, it can. We can assure you that in the next few years, this portfolio will be constructed to returning more than fixed deposits, which will be slowly phased out by banks.

Also, when one thinks about the fixed income portfolio, he should think about it in the broader context of an individual’s portfolio which consists of equities as well. The fact is, bonds have not fared well this month is also a reason that equities have. It is a trap to look at an individual asset’s performance all the time without looking at one’s entire portfolio and the asset allocation within it.

Finally, remember, fixed income pays interest every day. The return on fixed income is a combination of interest and capital gains or losses. Capital gains occur when interest rates fall and capital losses occur when interest rates rise. But you get paid interest in both the cases. The interest cushions your capital losses and magnifies your capital gains. This is why bond market weakness is sharp over a small period of time. People who are short of fixed income do not have time as they bleed interest while being on short of fixed income.

 

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