Dynamic income funds: Are they right bets in the delayed easing rates scenario?

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Dynamic Income Funds

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Mutual Fund Category Analysis November 16, 2012

Dynamic Income Funds: Are they right bets in the delayed easing rates scenario?Prologue: The RBI’s decision on keeping key policy rates unchanged in its latest Monetary Policy Review has created speculation about when interest rates would be cut. Though the Central Bank has indicated that it might ease policy in January to March, the final quarter of the fiscal year, it is still uncertain when that would materialize. Given the present and near term macro economic conditions in the domestic front, the RBI is likely to cut interest rates in Q4FY13 to boost growth and to support the ongoing Government efforts to stimulate the economy. But one thing is clear that the RBI will not start cutting rates aggressively till a moderation is witnessed in inflation so that it comes within its comfort zone. Hence one can say that there could be 25 - 50 bps rate cut till March 2013.

Debt Mutual Funds which can capitalize from this scenario: As far as Debt mutual fund schemes are concerned, long term income funds such as Gilt Funds – Long Term, Income Funds and Dynamic Income Funds can get benefit from such fall in interest rates and witness an appreciation in their NAV values. They are also long duration funds which means that these funds hold majorly longer maturity debt instruments in their portfolios and churn based on the changing interest rates in the economy.

Debt mutual funds gain in two ways - one from interest income and another from capital appreciation. Short term debt instruments whose maturity periods range from one day to one year mostly work on accrual basis to account for interest income. On the other hand, long term debt instruments can get benefit in both ways from the bonds from interest income and capital appreciation. Capital appreciation arises from the bonds once the value of the bonds rise. Interest rates and prices of debt securities move in opposite directions. When interest rates rise, the prices of debt securities fall. Likewise, when interest rate fall, the prices of debt securities rise. Hence, the longer duration funds will benefit and see an appreciation in their NAV values when interest rates start to fall.

Amongst the long duration debt categories, Dynamic Income Funds are more sensitive and respond fast to the environmental changes. They are better bets in falling interest rates scenario as they can churn faster into longer maturity debt papers. By virtue of being long duration, they could generate higher returns compared to other Gilt –LT and regular Income funds.

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Mutual Fund Category Analysis contd…

In this note, we analyze the comparative performance of Dynamic Income funds on various interest rate cycles the Indian debt market has experienced in the last five years.

Brief note on current macro economic conditions in the domestic front:

The RBI’s stance: In its latest Monetary Policy Review held on October 30, 2012, the RBI left the repo rates unchanged as 8%, amidst apprehension over persisting higher inflation in the domestic front. The central bank indicated that it might ease policy in the final quarter of the fiscal year given the assumption that the inflation would come down to 7.5%. Further, the RBI cut CRR by 25bps to 4.25% in order to inject more liquidity into the banking system.

Headline WPI inflation: The inflation which is measured by WPI has moderated from its peak of 10.9% in April 2010 to an average rate of 7.5% over the period January-August 2012 due to softening of prices of primary food articles.But from September there was a pick-up in the momentum of headline inflation owing to the increase in fuel prices and elevated price levels of non-food manufactured products. The inflation has fallen back to 7.45% in October. It is to be noted that the improved winter crop could reduce the pressure on the food inflation side and in the fourth-quarter the supply-side pressure on inflation should also ease; hence providing some room for the RBI to cut rates.

Systemic liquidity: Systemic liquidity conditions in the banking system witnessed crunch in the recent periods mainly on account of the build-up in the Government’s cash balances coupled with the seasonal increase in currency demand. This will pose risks to credit availability for productive purposes and could adversely affect overall investment. Despite the fact that the excess liquidity could aggravate inflation risks, cut in CRR rate and possible announcement of OMO purchases going forward will improve the liquidity condition in the system. Easing liquidity conditions will facilitate a turnaround in credit growth to productive sectors so as to support growth.

Growth Concerns: In the last one year period, Domestic economy has experienced a sharp slowdown in growth from 9.2% in Mar’11 quarter to 5.5% in June’12 quarter. Halted investment demand, moderation in consumption

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spending and continuing erosion in export competitiveness accompanied by weakening business and consumer confidence have muted the growth of the domestic economy. The recent policy announcements by the Government for revival in investment activity, which is key to stimulating growth has to be translated into effective action to convert sentiment into concrete investment decisions.

Hence, considering all the aforesaid conditions, one may assume that the RBI is likely to cut interest rates in Q4FY13 to boost growth and to support recent and ongoing Government efforts to stimulate the economy. However it is clear that the RBI will not aggressively start cutting rates till a moderation is witnessed in inflation which comes within their comfort zone. So it is likely to say that there may be 25 - 50 bps rate cut till March 2013.

WPI Inflation (Y-o-Y) Key Policy Rate:

The RBI maintained states quo in the latest policy review meeting given the persisting higher inflation in the domestic front.

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10R epo R ate M IB OR 10 Y (R H S)

WPI Inflation shot up again in September ’12 owing to the increase in fuel prices and elevated price levels of non-food manufactured products.

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What are Dynamic Income Funds? As the name suggests, Dynamic Income funds are debt mutual fund schemes which have flexible asset allocation structure of churning their investments into any debt instruments including corporate and PSU bonds, Government Securities, money market instruments, securitized debt etc of varying tenors. They have the leeway of going 100% only in cash or in Corporate debts or in Gilts or in any others debt instruments (prescribed) at any point of time.

The fund managers of dynamic funds can dynamically move from a fully invested situation to a cash position and various stages in between depending on the direction of interest rates. Dynamic Income Funds differ in strategy from normal Income and gilt funds where a normal Income funds have to maintain a balanced static proportion between gilts and corporate bonds while gilt funds have to go only with Government securities. In normal income funds, fund managers give equal importance to short term as well as long term perspective but in Dynamic Income funds, fund managers give importance to the cycle and try to capitalize from the opportunities.

Halted investment demand, moderation in consumption spending and continuing erosion in export competitiveness accompanied by weakening business and consumer confidence have muted the growth of the domestic economy.

Liquidity witnessing crunch in the recent periods mainly on account of build-up in the Government’s cash balances coupled with the seasonal increase in currency demand.

Muted domestic GDP growth (Y-o-Y): Tightening in liquidity condition in LAF window:

9.69.3 9.4

9.7

8.5

7.87.5

6.15.8

6.3

8.6

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9.4

8.8 8.9

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7.8 7.7

6.9

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5.35.5

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11

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p-07

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-180000

-130000

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55.566.577.588.599.510

Net injection (LHS) 10 Yr Yeild (RHS)

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Performance of Dynamic Income Funds:

The relative performance of the Dynamic Income funds has been notable over the periods of various interest rates cycles which the Indian markets witnessed in the past five years (see the table below). The Dynamic Income category managed to be in one of the first two positions in the ladder in the performance table for the all periods (of interest rate rise and fall) barring July ’08 to Sept ‘09.

Gray – 1st position. Yellow – 2nd position. Returns are tailing and absolute.

One thing should be noted that, in common, income funds can maintain a passive exposure to long dated paper at all points in time as per their objectives. On the other hand, dynamic funds would take tactical positions and bet as well as on the short end of the interest rate cycles as well. So the fund manager of the Dynamic Fund has to be cautious to get his call right every single time. But, that is practically impossible for any Dynamic Income fund manager to be perfect in all the time. The above table proves the same. However among different categories of debt schemes, dynamic category has done well in most periods.

Conclusion: Given the above fact, one can conclude that Dynamic Income funds are more suitable for short term investments for the time horizon of six months to nine months especially during periods when the interest rates witnessing a twist in their direction. Given in the present scenario of delayed easing rates situation where the interest rates are about to start falling in the near term, investors can consider investing in the top performing schemes from the category and stay for another six to nine months period.

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Various interest rate scenarios in domestic front:

The above table further shows the Short Term Income category outperformed in most of the periods thanks to the rise in short term interest rates during those periods. However, Short Term Income funds may not be able to actively participate in all the interest rate cycles like long duration funds especially if the short term interest rates are likely to remain soft for an extended period.

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10Repo Rate (LHS) WPI (LHS) 10 Y (RHS)

Rise………..| |………..Fall………| |……………………………Rise……………………………| Fall…,

The above chart portray the various interest rate cycles which were experienced by the Indian economy. The period between Jan '08 to Sep '08, the WPI inflation peaked 12.4% yoy due to global & domestic macro economic issues. The RBI raised the repo rate to 9% level during the period. July '08 to Sep '09’ is the period when the inflation moderated and went to -0.39% level while the repo rate was cut to 4.75% level. Feb '10 to Dec '11’ is the period which the inflation shot up 11% and was ticking close to double digit level. So the RBI increased the policy rates by 350 basis points during the period. Due to softening of prices of primary food articles, the inflation has moderated in the recent periods and further expected to cool off in five to six months down the line.

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Preferred picks from Dynamic Income Funds category:

The Dynamic Income category maintains a dynamic approach on investing in debt securities by actively managing duration in different interest rate scenarios. Their investment strategies are formed within these ranges based on macroeconomic fundamentals, interest rate view, key market technicals and flow of liquidity. Further, almost all the funds in the category follow the credit strategy in the short to medium end of the curve to provide liquidity and higher accruals.

As far asset allocation pattern is concerned, most of Dynamic Income funds witnessed an increase in their allocation into long term corporate bonds and gilt securities. In last six months, the allocation into corporate and PSU Bonds increased from 39% to 49% while the allocation into Gilts witnessed rise from 8% to 36%. At the same time, the exposure into short term debt instruments such as CD and CP has come down from 53% to 16% and 19% to 16% respectively. The above churning clearly show the fund managers’ expectation of fall in interest rates.

Portfolio:Note: Trailing Returns up to 1 year are absolute and over 1 year are CAGR. NAV/index values are as on November 08, 2012.

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Changes in the assets allocation in Dynamic Income Funds category over periods:

Modified Duration:

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Certificate of Deposit Commercial Paper Bonds & Corp Debt Government Securities

Modified duration measures the change in the value of a security in response to a change in interest rates. Modified duration follows the concept that interest rates and bond prices move in opposite directions. This formula is used to determine the effect that a 100-basis-point (one percentage) change in interest rates will have on the price of a bond. In other words, modified duration indicates the interest rate sensitivity of the fund. If you invest in a higher-duration fund, any interest rate cut will increase the value of your portfolio.

Let us assume that the modified duration for the Income Fund is 5.37 years. If interest rates drop from 7% to 6.5%, the value of this debt portfolio will rise by 5.37 x 0.50% = 2.685%. Similarly, when interest rates rise from 7% to 7.5%, the value of this debt portfolio will fall by 2.685%.

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The below chart shows the movement into the long duration papers by the dynamic Income category. Average Modified Duration as per the latest data shows for the category at 40 months which is higher than 27 months last year. However, Dynamic Income category has largely been in tandem with regular income category as far as Modified duration of the overall schemes are concerned. Majority of Dynamic Income funds in the category increased duration by increasing G Sec allocation; whereas the exposure to money market instruments and bonds was kept intact on expectation of liquidity situation getting more comfortable.

Modified Duration of long term debt categories over periods (in Months) :

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9.510 Yr G Sec Yield (RHS) Gilt LT Income Dynamic Income

Average Maturity:Average Maturity of overall Dynamic Income category witnessed increase from 19 months to 47 months in the last six months period. The overall Average Maturity of Income Funds saw an increase from 24 months to 45 months while Average maturity of Gilt Funds witnessed 67 months to 92 months.

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Assets allocation pattern by top performing schemes from Dynamic Income category over periods:

0%10%20%

30%40%50%60%70%

80%90%

100%

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Government Securities

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CD & CP

Birla SL Dynamic Bond: Reliance Dynamic Bond:

IDFC Dynamic Bond:

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Other Assets



CD & CP

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Other Assets



CD & CP

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Analyst: Dhuraivel Gunasekaran.

HDFC Securities Limited, I Think Techno Campus, Bulding –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Phone (022) 30753400 Fax: (022) 30753435

Disclaimer: Mutual Fund investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared by HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or

copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied

upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in this document. This report is intended for non-

Institutional Clients.

Dynamic income funds: Are they right bets in the delayed easing rates scenario?

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