Risk reward ratio in favour of AAA rated bonds maturing in 2-3 years: Dhawal Dalal, Edelweiss AMC

Dhawal Dalal, Edelweiss AMC, says investors in low duration fund investing in high quality assets can expect to make between 6.75% and 7.75% return with a fair amount of conviction.

Source: The Economic Times

Yields have already crossed the 7% mark and currently are at a 17-month high. What according to you are the key factors contributing to the hardening of the yields? Do you think the market was somewhere anticipating the CPI as well as the IIP data which came yesterday?

Normally three forces affect the bond market. One is a sentiment which has remained very fragile particularly October onwards when market participants learnt about the possible increasing government borrowing on account of the decline in government tax revenue collection. The sentiment has played a pivotal role in the recent hardening of bond yields in our opinion.

On the fundamental side, apart from the inflation and other macroeconomic data, bond market participants are also focussing on the possible demand supply dynamic going into the next year and are wondering if in the absence of any significant increase in the FII limits, the possibility of a further credit offtake after the recapitalisation is being done. How this incremental demand supply of bonds is going to be absorbed by the market and what implication it might have on bond yields will have to be seen, given that inflation is likely to remain on the upward band of the RBI’s expectation at least in the first half of 2018.

More importantly, with the 10-year bonds above 7% right now, the technical factors are also playing on market participants’ minds, given that the December 31st level of the benchmark 10-year above 7% could be very crucial from a technical analysis perspective.

These are the three indicators in my opinion — sentiment, fundamental factors as well as technical analysis – all of which are contributing to the recent upward move in bond yields. Particularly when market participants are waiting for some amount of clarification from the authorities on crucial aspects affecting the sentiments.


If the yield stays at 7%, what happens to projected returns for debt market for 2018 I am talking about pure debt schemes?

2017 has been a little disappointing year from the bond markets’ perspective after a very stellar performance in 2016. If you look at the returns of the different types of fixed income funds, duration funds — particularly bond fund and gilt funds — have underperformed the so called liquid fund and ultra-short-term fund category in 2017.

That said, we are optimistic that in 2018, the bond yields will perhaps stabilise or trend lower and that in turn could perhaps generate incremental return. This perhaps will be the crucial theme in the second half of 2018 but initially the first six months, the investors should focus on funds with low duration and high quality and liquid assets at this point of time. We prefer to invest in high quality triple AAA rated bonds given the kind of hardening that we have witnessed in their yield over the last two to three months.

We believe that the risk reward ratio could be in favour of the investors for AAA rated bonds maturing in two to three years in 2018.


If banks are recapitalised, their ability to lend would be better. We see that a lot of debt market flows have gone into corporate borrowings. If banks have the ability to lend more, why should you focus on schemes which have low duration and a AAA focus? Why do you think they will outperform?

In last two to three months, price action has suggested that the spread between AAA and non-AAA have narrowed and primarily from the fact that the supply of non-AAA assets in the primary and secondary market is relatively lower as compared to the AAA rated bonds that is number one. For example, AAA rated bonds of PFC and REC the yields have hardened anywhere between 20 and 25 bps in the recent move in bond yields and while the two non-AAA rated bonds have not seen that kind of hardening, it may be because of the lack of selling pressure in the bond markets.

From a relative value perspective, the AAA rated assets are looking better in our opinion. Second, as the credit cycle improves, we are going to see more supply coming in going forward in the bond market as more and more market participants and particularly borrowers are looking at avenues to borrow and in a situation where your inflation is trending higher bond market participants are focussing on low duration assets.

I believe there is a possibility that the credit spread between AAA and non-AAA asset could suddenly shoot up and at that point of time, it will be worthwhile to consider a non-AAA rated assets. But given the current situation where there is a pressure going on AAA rated bonds and the narrowing spreads, there is a value emerging in AAA rated bonds. We believe that the risk reward ratio is clearly in favour of investing in AAA rated bonds at this point of time.

Do you think we are stepping into a phase of a prolonged pause by RBI wherein rates are going to be retain status quo for some more time to come?
It is a little uncertain at this point of time. Most of the market participants expect the RBI to be on a pause for at least six months given the expected trajectory of the inflation. The upcoming Union Budget for FY19 will also perhaps give some clarity in terms of the government resolve to remain on the path of fiscal consolidation. That I think is playing on the investors mind.

Market participants are also very keen to see FII participation next year given that this year FIIs invested almost 1.7 trillion rupees worth of money in the government bonds, Indian bonds and despite that we have seen the yields hardening by about 70-75 bps this years. So, some of the critical factors are waiting to be cleared and we will have some more clarity perhaps in the first quarter of the new year going forward.

That said, if you look at the movement of the one year YS, it is perhaps fair to say that the market participants have perhaps begun to factor in a possibility of at least one rate hike in 2018 and while it is not fully priced in yet, at least it is beginning to get factored in. In a scenario like this, if in the global economy, particularly in the US, if there is emergence of inflationary pressures as some of the market participants are fearing, if the Fed and the G-7 central banks are beginning to communicate a little bit of hawkish view, then it will be interesting to see how the market reacts going forward in 2018.


Bond yields are currently at 7% which means if I am a simple investor I should be assured for 7% return. I would give money to a debt fund manager with the assumption that they would be able to give me a better spread of about 1.5% to 2% more. So can I safely assume for 2018 average debt fund investor should not expect double digit returns, the returns expectation should be somewhere between 7% to 9%?

It is a very simple way of expecting returns. In the bond market, there are two components of total return. One is the coupon accrual and the second thing is the price movement. Right now assuming that bond yields remain where they are, what you are going to get is the coupon and currently with the 10-year at around seven-quarter and assuming that bond yields remain where they are throughout the year, the investors will perhaps make only the coupon gains which is seven-quarter minus expenses.

However, investors are also looking for is a possibility of a price appreciation. Given that in the first six months, our view is that bond market could remain volatile or range bound, a price appreciation is feasible in the second half only provided the macroeconomic factors play out and the bond yields decline from there on.

It is difficult given the volatility in the markets particularly oil and the fiscal deficit and the demand-supply dynamics and the factors that we have discussed, it is difficult to take a call beyond three months at a particular time period and that is why we believe that right now investing in low duration funds where the price impact on bond yields going forward could be minimal, you have more clarity on the expected returns and over there, investors in low duration fund investing in high quality assets can expect to make between 6.75% and 7.75% return with a fair amount of conviction.