By Invitation. Watch out for state government loans

The bond market got a much needed respite in March, after a challenging first two months of 2016. The 10-year benchmark yield, which touched a high of 7.88 per cent, is now in the range of 7.55-7.65 per cent. The two key positives which turned the tide in favour of bond bulls have been the adherence to fiscal discipline and the inflation situation, which the RBI will keenly watch in setting the policy rates. Both have now turned favourable for the RBI to effect further monetary easing.

Additionally, the on-going open market operation (OMO) purchases by the RBI amid tight liquidity and the absence of primary supply have supported bond prices to a large extent.

Prior to the Budget, there was considerable uncertainty on the government’s intent to pursue the fiscal roadmap. Now, with a 3.5 per cent fiscal deficit target, one major hurdle for monetary easing has been passed. Much of the surprise was on account of the partial provisioning on the Seventh Pay Commission (65 per cent), which suggests pay hikes will be staggered over two years.

One may argue that there are several risks to the fiscal deficit estimate in terms of inadequate bank recapitalisation provision and lower revenues from asset sales. But I still expect the government to adhere to this target, given its past track record.

Another key positive for the fixed income market has been inflation. The last headline retail inflation reading for February 2016 at 5.20 per cent was significantly lower than expected even as core inflation moved up. On the growth side, the nominal GDP has to pick up, which, will happen but with a lag. Lower than expected CPI inflation, together with the desired fiscal rectitude, has cleared most hurdles for a 25 bps cut in repo rate to 6.5 per cent in the April policy meet. The latest cut in various small savings rates, by 40-120 bps , is also a step in the right direction. Beyond April, if the monsoon remains normal and the inflation situation remains stable, another 25 bps rate cut in the second half cannot be ruled out which, I believe, will be the last cut in the ongoing easing cycle.

There is limited downside scope for bond yields, as the market will now focus on the demand-supply dynamics.

One should keep in mind the increasing trend in state government borrowings through state development loans (SDL) which has been rising 20 per cent on an average in the past couple of years. The supply of SDLs can increase to ₹3.2 trillion in FY17 (₹3 trillion in FY16), which is over 50 per cent of gross central government borrowing and over 70 per cent at the net level.

With their additional yield kicker of 50-75 bps, increased supply of SDLs is likely to reduce the appetite for G-Sec, thereby adding pressure on overall yields. There are also concerns on the additional supply related to special SDL bonds under Ujwal Discom Assurance Yojana (UDAY) scheme to the tune of ₹1 trillion in FY17. Though there is no clarity on the extent of this supply hitting the market through private placements, a one-to-one swap between the distribution companies’ (discom) loans held by banks and UDAY bonds may alleviate some of these concerns. Nevertheless, the supply of SDLs is a major overhang on the bond market. In the corporate space, AAA bond spreads in the three to five-year segment at around 60 bps, appear reasonable considering the historical average of around 50 bps and our expectation of steepening yield curve. The 10-year corporate bond yields are trading at a spread of around 70 bps — higher than the historical average of 50 bps, primarily due to the rise in SDL bond yields.

Given the government’s preference for issuing longer dated bonds, average maturity of government debt can lengthen and supply at the shorter end of the curve can remain limited. The 10-year benchmark yield can consolidate in the range of 7.4 to 7.5 per cent in FY 17. However, yields curve will steepen. Risks to this view would be more than expected credit growth (11-12 per cent) which would then make the RBI’s OMO very critical. Additionally, there is $30 billion of foreign currency non-resident (FCNR (B)) deposits maturing in September this year, which can upset liquidity calculations.

The writer is Chief Investment Officer, Tata Asset Management

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