Inflation and Growth. You could be forgiven for assuming that these two are the major determinants in bond yield movement. However, a large part of the impact on long-term yields comes from demand-supply and with luck, there may be a new buyer in town.
Coming to the basics, RBI’s rate decisions are driven broadly towards controlling inflation and nurturing growth. Given the high inflation currently, RBI has been raising rates, and this immediately impacts the short maturity papers that are anchored to the policy rates. Currency depreciation can also make RBI act, even if inflation is under control, as was seen in 2013 and 2018.
Longer duration yields are additionally impacted by the fiscal policy and government borrowing plan (bond supply). Not to say that RBI’s action does not matter, as future rate actions also determine the longer duration yields.
Policy actions and term premiums
The significance of fiscal policy vs. monetary policy can be gauged through the term premium, i.e., the difference in the yields of shorter maturity and the longer maturity papers. Normally, longer the time horizon, higher the rates. But the play between fiscal policy and monetary policy can change the shape of the yield curve.
When the Government’s borrowing is large, the longer-term yields are comparatively high despite the RBI policy rates. This was evident during Covid-19, when government borrowed heavily and the term premium rose to an all-time high, despite RBI keeping the policy rates low.
For comparison, the term premium between 10-year and 2-year G-sec was 0.75 per cent in FY20. As government borrowings increased in FY21 and FY22, this premium rose to 1.5 per cent in FY22 and has now retraced back to FY20 levels.
To be sure, rate expectations also impact the term premium. If inflation is beyond RBI’s comfort, then any expected rate action has immediate impact on the shorter duration yields, but not so much on the long-term yields. This can at times lead to flat, or even inverted bond curve yields. This phenomenon can be seen in US yield curves currently, where short term yields are much high due to impending Fed hikes.
Today, the central government borrowing size is still large. It would usually lead to a significant strain in the longer duration yields. However, the State governments, benefiting from Centre’s transfers, have reduced their borrowing in so far in FY23, and that has provided some relief – though this may not continue.
Moreover, while current environment has differences with 2013, but if (i) the dollar strength leads to continuous outflows and (ii) the high oil prices lead to large current account deficit, then RBI may have to take more policy tightening decisions.
Thus, the major risks to bond yields emanate from (i) high government borrowing in residual year, and (ii) risks of currency depreciation.
Fresh global flows to come through
So, we need new buyers (demand) – and therefore bond inclusion matters. Such inflows can be sizeable. While the index-related inflows will probably come in next fiscal, we may still see sizeable inflows this year as global funds increase weightage to India.
Besides, buyers for the bonds will also provide foreign currency inflows into India and alleviate risks to potential currency depreciation – any near-term trade imbalance or current account imbalance gets funded. The need for RBI to hike rates or tighten liquidity on this count reduces.
The 10-year Indian bonds have rallied in past fortnight as the yields have reduced below 7.20 per cent, despite global yields ticking sharply higher. This is probably due to noise around global bond inclusion.
The basis of this noise seems to have arisen out of the need for the bond indices to include a credible market for their longer-term investment, as political risk has hit other nations bonds, specifically Russia. However, if it does not fructify, we could see a reversal or recent rally, even as we remain hopeful for the longer term.
Yields heading lower, bond fund choices
And this makes the bond inclusion a game changer and could determine whether 10-year bond yields move significantly below 7 per cent, else they may move above 7.50 per cent. A demand driven rally (caused by inclusion) can lead to yields being low for a long time – making the recent yield levels as the peak for this cycle.
Rolldown funds may perform if bond inclusion occurs, but constant maturity funds like 10-year constant gilt funds or medium duration funds may perform even better as they will leverage consistently higher duration.
For Investors who do not want to take event risks of bond inclusion, active funds such as gilt funds that navigate duration should be able to navigate the event-based volatility better. Gilt funds also benefit from the fact that (i) bond inclusion will lead to inflows in gilts, and (ii) corporate spreads are already very narrow.
The author is Head of Fixed Income DSP Mutual Fund