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Big Story | Will bond yields rise in 2020?

Radhika Merwin | Updated on February 25, 2020 Published on February 22, 2020

While bond yields fell sharply in 2019, it was no walk in the park for investors. Will the bond market’s roller coaster ride continue in 2020? We look at key macro economic factors to find out

It was a rocky 2019 for bond markets, even as long-duration gilt funds regained some of their mojo after a tepid show in 2017 and 2018.

While the yield on 10-year government securities fell sharply by 90-100 basis points and bond prices rallied, the Indian bond market remained volatile through most of 2019, weighed by concerns over slippage in fiscal deficit and rising inflation. Will the ride for the bond market be just as bumpy in 2020?

Rising inflation

 

 

Ever since the RBI adopted the inflation targeting framework about five years ago, monetary policy actions have been led by the movement in CPI (consumer price index) inflation. The RBI’s inflation target is set at 4 per cent with a range of +/-2 per cent. With CPI inflation remaining within the 3-4 per cent mark through most of 2018 and 2019 (until September), the RBI lowered its repo rate (the rate at which banks borrow short-term money from the RBI) by 135 basis points between February and October 2019 — the 10-year G-Sec yield moved down sharply by 100 basis points by July 2019. But the CPI inflation moving past the RBI’s comfort level of 4 per cent, to a 16-month high of 4.6 per cent in October, played spoilsport.

The RBI chose to pause and retain the repo rate in its December policy.

The 10-year G-Sec yield moved up by about 50 basis points between July and mid-December.

As if on cue, the CPI inflation data for December that came in subsequently, spiked to 7.35 per cent, led by a sharp increase in vegetable and pulse prices. Core inflation (excluding food and fuel) that had been moderating until then, also started to inch up. Above all, after five consequent months of negative growth (deflation), fuel inflation came at a positive 0.7 per cent in December.

In January, CPI inflation inched up further to 7.59 per cent levels, the highest level since July 2014.

Our view

Up until now, CPI inflation was led by the sharp rise in food inflation (mainly due to rise in vegetable and pulse prices).

What is of concern now (after the January data) is that the rise in inflation is becoming more broad-based.

Within food, even as vegetable inflation has cooled off a bit, prices of meat, fish, egg, milk, pulses and oilseeds have increased substantially in January. Hence, the stickiness in food inflation could persist for a long time.

The other key concern is the notable rise in core inflation. From 3.8 per cent in December, core inflation has shot up to 4.2 per cent in January 2020. Aside from housing, there has been a marked increase in all segments. Health (4.2 per cent), transport and communication (6.1 per cent, owing to a spill-over effect of telecom tariff increase), recreation (4.5 per cent), education (3.9 per cent) and personal care (7.2 per cent) — all saw a significant uptick in January. Fuel inflation also inched up to 3.7 per cent.

To cut a long story short, headline CPI inflation could remain at 5-6 per cent levels through most of 2020.

Bottom-line

Inflation at elevated levels implies the near-end of monetary easing through repo rate cuts.

Fiscal worries

 

All the high drama around the fiscal deficit ended with the Budget, with the Centre slipping sharply on its target. The Centre revised its FY20 fiscal deficit to 3.8 per cent (from 3.3 per cent forecast in last year’s Budget). But the numbers still do not add up. The Centre has set ambitious targets for disinvestment, income-tax collections and receipts from telecom AGR (adjusted gross revenue)/spectrum). Hence, achieving even the 3.8 per cent target appears a tall task.

The revenue assumptions for FY21 are even more ambitious. The Centre has pegged growth in IT collections for FY21 at 14 per cent, which is optimistic.

The bigger worry is the Centre’s reliance on huge one-off revenues from disinvestment (₹2.1-lakh crore) and the telecom sector (₹1.33-lakh crore) in FY21.

Above all, the 10 per cent nominal GDP growth assumption for FY21 has completely glossed over the current economic slowdown. Hence, meeting the 3.5 per cent fiscal deficit target for FY21 appears very difficult.

Our view

What matters more than the fiscal deficit ratio is the quantum of borrowings to fund the deficit. Interestingly, despite the sharp slip on the fiscal deficit, the Centre has managed to please the bond market with a comfortable gross borrowings figure for this fiscal and the next.

In the Budget last year, the Centre had estimated gross borrowings for FY20 at ₹7.1-lakh crore.

In this year’s Budget, even as the FY20 fiscal deficit ratio was revised up to 3.8 per cent, borrowings were retained at ₹7.1-lakh crore. This was done by pegging in additional borrowings from small savings funds (₹2.4-lakh crore against the budgeted ₹1.3-lakh crore).

While this has warded off a sharp rise in yields for now, it has left very little wiggle room for the Centre. A sharp miss on disinvestment/telecom proceeds could lead to additional market borrowings (as it has already exhausted the leeway to borrow from other sources).

The gross borrowings figure of ₹7.8-lakh crore for FY21 also appears significantly understated.

There is also the issue of a steep rise in State borrowings. For the current fiscal, gross State borrowings have been about ₹4.67-lakh crore (up to February 7). Going by the weak State finances, Centre and State borrowings put together could be a staggering ₹14-15-lakh crore in FY21.

Bottom-line

Oversupply of bonds in the latter part of 2020 could add upward pressure on bond yields.

Demand dynamics

 

One of the key factors at play in the bond market is the demand for government bonds, both from domestic as well as overseas investors.

On the domestic front, the appetite for government bonds in 2019 appeared tepid. PSU banks have been net sellers for two consecutive years, net selling ₹58,330 crore in 2019 and about ₹76,500 crore in 2018.

While private sector banks were net buyers in 2019, the amount moderated significantly from 2018 levels — ₹44,300 crore in 2019 vs ₹57,196 crore in 2018. In 2020, PSU Banks have remained net sellers.

Foreign investors were also not too keen to lap up Indian government and corporate bonds in 2019. While they were net buyers to the tune of ₹25,800 crore in 2019, they were not very gung-ho about buying Indian bonds, going by their utilisation status. FPIs (foreign portfolio investors) utilised barely half of their investment limits in government bonds in 2019.

The interest was particularly tepid in the ‘long-term FPIs’ category (that include sovereign wealth funds, endowment funds andpension funds). Currently (as of February 20, 2020), FPIs have utilised only 51 per cent of their limits in government bonds and 58 per cent in corporate bonds.

In a bid to encourage more foreign flows, the RBI had made some tweaks in the investment limits in January. It increased the FPI limit under Voluntary Retention Route (VRR) to ₹1.5-lakh crore from ₹75,000 crore. VRR was introduced in March 2019 — a carve-out limit available to FPIs, wherein conventional regulatory norms do not apply.

But doubling this limit may not immediately have a significant impact on flows. As of February 18, of the VRR investment limit of ₹90,630 crore, ₹5,856 crore has been allotted. The RBI had also increased the limit for short-term investments by FPIs to 30 per cent (from 20 per cent) of the total investment in either Central Government Securities (including Treasury Bills), State Development Loans or corporate bonds.

This year’s Budget also had some proposals to improve foreign flows into Indian bond market — hike in FPI limit in corporate bonds to 15 per cent (of outstanding) from 9 per cent and to fully open certain specified categories of government securities for non-resident investors.

Our view

Higher real interest rate and stable currency have always been a big draw for FPIs. The 10-year government bonds in India today offer a yield of about 6.3 per cent; in the US, 10-year gilt offers about 1.5 per cent. On a nominal basis, Indonesia is another country that offers comparable interest rates (to India) on its 10-year bonds, at 6.4 per cent.

Indonesia’s inflation is currently at 2.68 per cent, which implies a tidy 3.7 per cent of real interest rate.

But with India’s CPI inflation moving past the 7 per cent mark in December, real interest rates (nominal, less inflation) have turned negative.

The repo rate at 5.15 per cent implies a transient, but worrisome, 240 basis point negative real rates.

In the recent weeks, flows into global bond markets, including India, have increased, owing to the fallout of the coronavirus. With the slowdown in global growth expected to intensify and most central banks to retain their accommodative policy, flows into Indian bond markets could continue in the near term.

However, this could be short-lived, as fiscal deficit and inflation come back into focus in the second half of 2020.

The RBI’s relaxations on the FPI front (along with Budget moves) are unlikely to increase flows in the near term.

They may, however, help prep the pitch for Indian bonds’ inclusion in global bond indices. But this would be a long-drawn process and would not lead to flows immediately.

Bottom-line

Demand could remain tepid in the latter half of 2020. Substantial improvement in FPI participation will depend on inflation, rupee and fiscal deficit conditions.

RBI measures offer relief

 

Over the past year, the RBI ensured ample liquidity to banks, alongside tidy cuts in repo rate. But the wide spread between the yields on 10-year government bonds and shorter-tenure bonds impeded transmission. In a bid to ease the interest rates on long-term government bonds, the RBI has been announcing ‘operation twist’, using proceeds from the sale of short-term securities to buy long-term government debt papers. This, to some extent, has helped lower the yield on long-term G-Secs.

But what triggered the recent rally in government bonds is the RBI announcing (in February policy) long-term repo operations (LTROs) for one-and three-year tenors amounting to ₹1-lakh crore. The LTROs ensure cheap long-term money to banks (at the current repo rate of 5.15 per cent). The demand for the first three-year LTRO conducted by the RBI recently has been massive, with banks bidding for 7.7 times the funds on offer (₹25,000 crore).

Given that banks straight away earn a tidy spread by investing the LTRO money in corresponding-tenure government or corporate bonds, demand for bonds can remain upbeat in the near term.

Our view

With very limited scope to cut repo rate further, the RBI will have to use other tools in its kitty to ease interest rates.

Ensuring durable liquidity, undertaking operation twist to manage long-term bond yield and conducting long-term repos should offer respite to bond markets in the near term. However, as we progress into the year, worries over fiscal deficit and, in turn, oversupply of bonds and inflation, would come under focus, again.

Given the otherwise weak appetite (before RBI’s measures) for bonds, healthy FPI participation and continued operation twist will be critical.

Bottom-line

In the near term, 10-year bond yield could remain at 6.3-6.4 per cent. However, fiscal deficit and inflation remain the joker in the pack, which can lead to volatility later in the year.

What investors should do to reduce volatility in returns

The fiscal deficit math does not look too comforting. The overall public borrowings is a large figure, and inflation could remain elevated through most of 2020. Aside from RBI measures bringing near-term relief, bond yields could be volatile and also move up in the second half of 2020. What do all these mean for you as a bond investor?

The NAV on your debt fund can rise or fall along with the underlying bond prices. Debt funds invest in various fixed-income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments.

One key determinant of bond prices is the interest rate movements.

If the rates move up, bond prices fall, as investors flock to newer bonds that offer higher rates. This reduces the attractiveness of older bonds, and hence, their prices decline. The reverse holds true under a falling rate scenario — bond prices move up.

As longer-duration bonds are more sensitive to interest rates, you are more prone to interest-rate risk in long-term gilt funds.

Avoid duration

Given the uncertainty over bond yields, investors must tread with caution. While long-duration gilt funds made a comeback in 2019, delivering 10-11 per cent average returns, the road ahead could be bumpy. Hence, if you are a conservative investor, don’t jump the gun on duration yet.

If you have a moderate risk appetite and want some piece of the rate action, dynamic bond funds that have the flexibility to juggle between short- and long-term bonds are a good option. Active management of duration by the fund managers helps these funds contain downside in an iffy market, while making the most of bond rallies. In the past one year, dynamic bond funds delivered about 7.5 per cent return.

Go for short-term debt funds

A chunk of your debt fund investments should be in short-term funds that carry less volatility in returns. Short-term income funds and banking and PSU debt funds are good options. Short-term income funds invest in debt securities that have a maturity of up to four years. Their portfolios usually have a small allocation to long-term gilts and higher allocation to AAA rated, medium-tenure, corporate bonds.

Banking and PSU debt funds offer stable returns, a good play on rate movement on the shorter end of the yield curve and relatively low credit risk. These funds invest mainly in debt instruments issued by banks and public sector undertakings.

Avoid credit risk

Bond prices are also impacted by the credit risk — the ability of the bond-issuing company to service the debt obligation. Hence, debt funds can also incur losses if they make wrong credit calls. Given the growing instances of credit defaults and the worsening economic slowdown, investors should avoid taking high credit risk. Opting for corporate bond funds that invest a chunk of their assets in high-rated debt instruments may be a good way to mitigate credit risk in 2020.

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Published on February 22, 2020
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