Dynamic bond funds are expected to deliver better returns with gilt yields set to remain in a range for some more months, says Dhawal Dalal, Head – Fixed Income, DSP BlackRock Mutual Fund.

We are on the hold with policy rates over the last few meetings. What is your view on rates now?

The RBI Governor has made it clear that he wants to see inflation come down on a sustainable basis before he brings down rates. Inflation has two main aspects — food prices and inflationary expectations. The food prices inflation that is heading higher is going to play a key role in future.

Then inflationary expectations, based on the RBI’s survey of consumers, continue to remain high, in excess of 12 to 13 per cent. If consumers feel that inflation is going to remain high, it will be difficult for the RBI to reduce rates. Based on these, we feel that the RBI will maintain rates at the current level at least till the second quarter of 2015.

Do you think the external environment is important since the Fed will soon start raising soon?

Currently, looking at the Federal Reserve’s own expectations, they will have to start raising rates in the first half of 2015. The RBI will try to ensure that the Indian economy is insulated from whatever move the Federal Reserve or any other central bank takes. They will perhaps do this by keeping rates elevated and the currency under control with low volatility so that in case of reversal of flows from emerging markets to developed countries, Indian financial markets are least affected.

Do you think the interest rate spreads between India and other countries is sufficient or is there a case for hiking rates?

That is a valid point. But the RBI has not commented on the spread between India and other countries so far. If you look at the historical spread, we are at the higher end of the band. Currently the spread is about 600 basis points. This is higher by about 150 basis points than the long-term average. Whether this is sufficient or not, only market participants can tell.

If we compare real rates, there is hardly any difference. Does that mean RBI has to take rates higher? Perhaps not, because the economy will not be able to bear any further increase in rates.

Why are foreign portfolio investors bullish on Indian debt securities?

Foreign portfolio investors would like to take a duration risk. My understanding is that the bulk of investment is happening keeping the level of the rupee in mind. On a quarter-to-date basis and on a year-to-date basis, the rupee has underperformed other Asian currencies.

We have a situation with undervalued currency and elevated bond yields; Indian bond yields are the second highest in the region. That brings in investors who are here for the longer term.

But assuming that the returns are unhedged, bulk of the returns will come from currency and not from bonds. So they are likely to react more to currency moves.

The performance of your gilt funds over the last one year has not been good. What is the reason for that?

If you remember last year, Q2 and Q3 were very volatile due to the announcement of taper and then with the currency stabilising with various measures taken by the RBI. As a result of this, the benchmark touched a low of 7.10 and went all the way to 9.5.

Because of this wild movement, gilt funds that had investment in longer-dated government bonds have underperformed.

Given your interest rate view, what is the strategy you are adopting with respect to your funds?

For income funds a prudent mix of corporate bonds AAA and non-AAA and government bonds will be the optimal way for getting good returns. As far as gilt funds are concerned, we are investing in government securities maturing between 2020 and 2028. We are not increasing our allocation to very long dated bonds.

Your income opportunities fund has given good returns. What is the strategy adopted there? Has it been a credit call or a play on the duration?

With the improvement in the economy, we think that credit risk is also reducing and liquidity is improving.

In income opportunities fund, we are taking selective credit risk by performing due diligence on certain credit, meeting the management, understanding the business and the prospects and the requirement of credit and then investing in such a way that our total exposure to a high yielding asset is not more than 50-55 per cent.

We have invested in bonds rated lower than AA also. But this is based on our understanding of the credit, the collateral and other safety features of the asset. And the rest of the portfolio is invested in safe liquid assets to balance any liquidity need in the future.

What is your outlook for gilt, dynamic or short-term funds? What are the strategies you are adopting in these funds?

In gilt funds we do not see an immediate decline in yields. The government bond prices are, therefore, expected to remain range-bound.

In dynamic funds we are looking at a mix of government and corporate bonds. We are, therefore, different from our peers who are overweight government bonds and underweight corporate bonds. This strategy is designed to reduce volatility and optimise performance. If we anticipate that government bond yields are going to decline sharply, we will immediately increase our allocation to government bonds.

Short-term funds are mainly invested in corporate bonds maturing up to three years, with the average maturity of two years. We take selective government bond exposure not exceeding 10 per cent in the fund.

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