January 13, 2009

An entry point for getting into bonds

Last few months have been extremely conducive for traders, including day traders and jobbers. Not just in equities, but even in currencies and commodities. With the introduction of currency futures in September 2008, punting in that space have become fairly convenient too. However as a retail trader, bonds are still inaccesible to me for direct trading. Ironically, my best trading views and most of my high conviction ideas are in that space. Anyways, trading in equity derivatives and currencies have been fun and excitingly profitable. I am not a commodities person. As of now!

Whilst I am incapable of trading in bonds directly due to logistical issues including big lot sizes, I can translate my views into money through open-ended gilt schemes. I have been bullish on bonds since September 2008. We have already seen a super-rally in bonds. The benchmark 10-year yield has eased from 9.50%+ levels to sub-5.25% levels over the last 3-4 months. Despite that, there is still some juice left in bonds, more so on a relative basis vis-a-vis equities. The 10-year yield is currently trading close to 5.70% level. The market witnessed a huge bout of correction and profit-booking during the first few trading sessions of 2009 till yesterday. The primary trigger for the sell-off was the Rs.50,000 crores fresh borrowing announced by the government for the last three months of the current fiscal. That, and the fact that we had rallied a lot (and pre-maturely perhaps), resulted in a correction of a good 90bps over the last one week. 1% change in yield of 10-year government bond is equivalent to approximately 7.10% change in the bond price.

Where do we stand now? Let us look at the negatives first. Firstly, higher supply is pain for bonds. Secondly, the generic demand in the form of SLR might be moderating with lower deposit growth. Bank deposits are growing at 21% for few fortnights now, lower than the 25%+ that we have seen last year.

Among the positives:

The biggest driver will be falling inflation. With fuel prices expected to be cut again in a couple of weeks, we could see inflation falling more starkly. At a time when the policy makers are trying to revive growth, real interest rates cannot be higher than 2%-3%. Year-on-year price change will soon be negative. So, we will see the overnight Reverse Repo rates and CRR cut by at least 75bps-100bps pretty soon. Liquidity remaning in the positive regime and call rates at sub-4%, 10-year yield cannot stay at these levels for very long. The 10-year over call rate spread should be at a high of 50bps-75bps at the peak of the markets. So if call rates do trade at 3.5%, 10-year yield can surely see the sub-4.50% levels.

Corporate results and industrial/manufacturing growth has few more quarters before showing signs of strength.

Net net, there exists not many reasons to keep yields high. At current levels, one could buy bonds and expect atleast 10% returns in a time-frame of 4-6 months, conservatively. That's 20% per annum! Not bad at all.

About my portfolio: I have invested in the ICICI Pru Gilt Fund - Investment Plan. With an average maturity of 16.66 years, modified duration of 9.15 years and backed by a decent corpus of 716crs (as on 31st Dec. 2008 - sourced from their fact sheet), it is perhaps the best bet for the above-mentioned view.

Happy investing!

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