Hedging Fixed Income in Volatile Times
The Indian CPI print at the beginning of last week has served to substantially take up average 2021-22 forecasts for most analysts.
The US Fed meeting seemed to sound more cognizant of inflation risks than the market was prepared for the Fed to acknowledge at this point. This was reflected both in the average inflation forecasts for FOMC members as well as their expected rate hikes down the line, in 2023. The outcome caused substantial (albeit fleeting) price action mostly as a result of market positionings getting mis-footed. Thus the dollar index climbed, commodity prices generally fell, US long-end yields fell and short-end yields rose; precisely the converse of most market positioning leading up to the Fed meeting. However, markets have had cause to stand back, reassess, and somewhat realise that the underlying US monetary policy framework resulting in a deliberately ‘behind the curve’ Fed (as compared with previous tightening cycles) is alive and things seem to be settling back down.
How We are Thinking About Portfolio Hedges
One must actively think about putting in place some defenses for risk management. This in turn can be looked at in 2 ways: 1> outright cut bond positions and raise cash in portfolio, and/or 2> ‘pay’ swaps (OIS) against bond positions to reduce maturity.
The chart above tracks the spread of 5-year government bonds over 5-year swap for the last 10 years. The spread has reduced considerably since early 2020 and currently stands at a significantly lower level than its average over these 10 years. This shrinkage coincides with the RBI’s intent of assigning significant weightage to the evolution of the yield curve as reflective of financial conditions in the system and its consequent interventions to manage the yield curve. The current bond-swap spread still reflects the overhang of this policy since RBI hasn’t had occasion yet to administer any modifications.
The elevated level of general government debt and the higher than usual annual issuances of paper that might be in place for the next few years is a stress point for India’s macros.
RBI might have a long drawn rate adjustment cycle. Even though the short-term cyclical bounce may be strong for the local economy, it may take much longer for purchasing power and confidence to heal for the aggregate of Indian consumers.
Looking at Portfolio Yields Dynamically
Portfolio yields must be looked at somewhat dynamically. Thus after a 3-year bull run in bonds if the portfolio manager is creating some hedges and flexibilities that in turn are showing up as a reduction in yield, then this may even be looked at as a source of comfort for investors. Similarly, if corporate / credit spreads have narrowed to unsustainable levels in some cases and the manager hence decides to move to more quality assets, this could be a move to protect against future risks to spread expansion even as it entails some dilution in portfolio yields of the current portfolio. Thus a static analysis of portfolio yields and choosing the highest of these for every category of funds may not optimise risk versus reward, especially at cycle turning points.
The author is Head – Fixed Income, IDFC AMC