Money & Banking

With interest rate hike mostly factored in, bond markets remain resilient

Radhika Merwin BL Research Bureau | Updated on August 01, 2018

Taking cues from the bond market, banks have been raising deposit and lending rates since January this year.   -  KSL

But rising inflation, concerns over fiscal slippages, and depreciating rupee could lead to hardening of yields

With the yield on 10-year government bonds already having moved up by a tidy 140 basis points over the past year, the RBI’s rate hike on Wednesday, understandably, did not rattle the bond markets. The yield on the 10-year G-Sec continued to hover around the 7.7-per cent mark. The central bank maintaining a neutral stance has also given the markets a breather. That said, given that there are several risks to the RBI’s projected inflation for FY19, further rate hikes can hardly be ruled out.

Rising concerns over the Centre’s fiscal slippages, depreciating rupee, unfavourable demand-supply dynamics in the bond market, and liquidity conditions remain a key overhang over bond markets.

Fiscal worries

The fiscal deficit has reached 68 per cent of the target so far. Concerns over GST collections, post lowering of rates, and increase in government spending in the run-up to the general election in 2019, have increased the risk of fiscal slippage. Aside from the uncertainty over the Centre’s fiscal policy, the rise in States’ fiscal deficits is also a concern.

The RBI conducting open market operations – purchase of government bonds – has thus far helped ease liquidity and cap the rise in bond yields. Further, OMOs can cool off yields to some extent and cap the upside.

One of the key factors at play in the bond markets has been the ample appetite for government bonds, both from overseas as well as domestic investors, in 2017. This has reversed in 2018. Foreign portfolio investors (FPIs) have pulled out about $6.19 billion from Indian debt so far this year. On the domestic front, PSBs had bought government bonds to the tune of about ₹40,673 crore in 2017 (including T-bills and SDL). In 2018, so far, they net sold about ₹19,000 crore of government bonds.

Falling rupee

The relatively higher interest rates in India have always been a big draw for foreign investors. With US bond yields currently at 2.95 per cent levels, and India 10-year G-Sec at 7.8 per cent, the spread is around 500 basis points, which is in line with the historical average. But aggressive hike in US rates can trigger more outflows from emerging bond markets.

Also, aside from higher returns, foreign investors draw comfort from the stability of a country’s currency. The rupee is one of the worst-performing currencies this year, depreciating 7 per cent against the US dollar.

The yield on the 10-year G-Sec should trade in a narrow range of 7.7-7.9 per cent in the first half of the fiscal and move up notably in the second half.

For the investor

As longer duration bonds are more sensitive to interest rates, investors should avoid investing in longer term gilt funds. SEBI’s rigid categorisation has made fund selection easier for investors with a specific risk profile and investment horizon.

Short duration – one of the categories – requires investment in debt instruments with duration (Macaulay) between one and three years. Investors with a low to moderate risk appetite, with a similar investment horizon, can invest in short-duration funds that carry lower interest rate risk.

Published on August 01, 2018

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