The other elephant in the room – Fixed Income
The other elephant in the room – Fixed Income
While equity as an asset class offers a realistic possibility of making 15% p.a. over the long term, there is nothing wrong in playing the cycle well in other asset classes too. There are many periods in the past decade where debt mutual funds delivered double digit return over 3 years while equity market struggled during the same period.
In 2008 one could place a 1 year FD at 10.5%
In 2013 one could buy duration funds and pocket 12% p.a. over 3 years Credit funds delivered 9%+ p.a. for almost a decade
The 10 year rolling return of the 10 year G-Sec in India still exceeds 8% p.a. gross
Fixed income is cyclical, if one can play the cycle well one can boost the overall portfolio return without having to take too much risk in equities. For a typical portfolio that has 40% equity and 60% in fixed income, a rise in FD rate from 5% to 8% adds 1.8% to the overall portfolio return.
We’d written a post dedicated to fixed income investing towards the mid of 2022, now is a good time to revisit this and fine tune your approach as we start approaching peak rates in India in this hike cycle.
At the same time please do not assume that this rate hike cycle will be followed by an immediate rate cut cycle. The RBI may not be able to move conclusively unless the US Fed can conclusively communicate on their rate trajectory. The Fed is right now caught between the devil and the deep sea, inflation needs taming but their banking system needs liquidity due to the large MTM losses on the bank’s bond portfolios. Offering a liquidity line while raising rates is not easy to sustain, speculative asset classes saw a clear spike (watch crypto prices over the past week) once the liquidity tap was opened again. QT (Quantitative Tightening) may well turn out to be a damp squib, but that is complicated stuff.
Our base case for rates is that inflation may show a YoY decline in H2 CY23 but that may not be enough for central banks to declare victory yet. No point coming to hasty conclusions on macro trends, let them play out and hedge your bets in the meanwhile.
So what are we doing on fixed income portfolios right now?
Switching out from bank FD’s to liquid funds since the net YTM is 7%+ p.a. We already have exposure to a few short terms funds that have > 8% YTM at a modified duration of ~1.5 years
We are waiting for the right time to get into duration play (mod duration 4-7 years). Unless an opportune time presents itself, we may choose to not play this at all We will be happy to lock in money for 3 years+ once FMP’s that offer 8.5% YTM at low credit risk are launched. Post tax return here can be 7.75%+ under LTCG
While the equity market will keep gyrating to macro moves, US Fed RBI and what not, fixed income market that usually constitutes 50%+ exposure in most portfolios presents the possibility of 8% p.a. return after a long time. We believe the time to move is now. Take a look at your asset allocation, decide what you can lock in for 3-4 years into fixed income and start making those bets now. Long duration exposure should ideally be played through an active approach through bonds, but duration funds are a good alternative for those who can’t take this route.
Coming to the equity market, the pockets that have shown relative strength and outperformance from CY22 continue to be the same. Looks like the Govt is the only center with spending power for the next few months, businesses that feed into this chain are the few ones that have healthy near term visibility. Going forward we see ourselves limiting new additions to either of the following scenarios –
Valuation reasonable & visibility of healthy earnings growth over 1Y Valuation cheap & limited visibility of good earnings growth over 1Y, but healthy chances of mean reversion over 3 years
We’ve been booking out of stocks that are stuck midway. We think the risk is more to the downside than to the upside on valuation multiples right now, decisions should be driven off 10 year averages rather than 5 year averages for the quality pack. When in doubt stay in a liquid fund and pocket the easy 7% p.a. One needs a lot of clarity in thinking and execution right now.
Running with non consensus value bets still calls for bravery, high active share (variance from the benchmark constitution) in the portfolio rules out average returns over the medium term. With this approach one will either beat the benchmark easily or underperform by a lot. The funds that were the best performers in the 2018-21 cycle are now struggling in the bottom quartile, those that were struggling are top of the pack. The cycle is just mean reverting but is turning out to be painful for many.
Our DNA is that of active managers who don’t mind sticking their neck out, you will not see us becoming the proverbial cat on the wall and doing index hugging. Based on the FYTD return we seem to be on the right track so far.