Mutual Funds

I see 10-yr yield nearing 6.5% by fiscal end: Mahendra Jajoo of Mirae

Maulik Madhu BL Research Bureau | Updated on July 24, 2021

Low-duration and short-term funds suit debt investors at this juncture

The RBI is doing all it can to keep bond yields under check in the backdrop of the government’s large borrowing programme. The rising retail inflation isn’t helping matters but is creating a conundrum. Mahendra Jajoo, CIO, Fixed Income, Mirae Asset Investment Managers India, shares his views with BusinessLine on what to expect, going forward.

There is a stand-off between the RBI and the bond markets, with the central bank trying to keep the 10-year g-sec yield anchored close to 6 per cent, using all the tools in its arsenal. For how long will the central bank be able to keep the 10-year yield in check?

I think the RBI has done a commendable job so far. It has used all kinds of tools, including the GSAP or government securities acquisition programme. It is important that, right now, interest rates be kept under check because growth is under a cloud due to the second wave and the possibility of a third Covid wave. The question whether the RBI can continue to do this or not is relevant because there is a huge supply of government bonds. Supply is expected to be around ₹10 lakh crore out of which ₹5 lakh crore will be absorbed by the RBI through GSAP/OMOs. So, I think the supply overhang will be addressed in due course of time.

The real challenge is coming from the external front because we are seeing inflation go up in countries like the US. The US Fed has also given the first signal of tightening, going forward. In India, the May inflation numbers threw up a challenge. But given the volatility in inflation (up from 4.2 per cent in April to 6.3 per cent in May), we can wait for a couple of quarters to see whether inflation persists. My expectation is that inflation will come down in another three months’ time.

In my view, the RBI will be able to retain the g-sec yields as long as there is no challenge from the external front. And on that, our view is that global inflation has peaked out or is about to peak out. At most, the Fed will reduce its bond buying programme, which means that the liquidity that has already been injected will remain. Commodity prices have also begun to stabilise. So, I don’t see a serious challenge to the RBI being able to maintain the low interest rates.

The 10-year benchmark g-sec yield has risen from 6 per cent in early June to 6.14 per cent now and even if it rises to 6.25-6.50 in the second half of the year, that’s not like hard tightening of interest rates. So, the RBI should largely be able to maintain this interest rate environment for a reasonable period of time.

Is the bond market worried about expansion in fiscal deficit due to the additional relief measures announced by the Centre to combat the second wave? Are inflation concerns also weighing on bonds?

The market is becoming more and more comfortable with the fiscal deficit. The Chief Economic Advisor mentioned in an interview that the fiscal deficit for FY22 will stay at the projected level. Out of the extra ₹1.6 lakh crore planned for the States, ₹75,000 crore has already been disbursed without any extra borrowings.

We are seeing two things — one that growth has become a little bit slower, but then the industrial segment has largely been operational even during lockdown. So, the revenue side of the fiscal deficit will not be affected very significantly. The impact of the financial relief package is also not huge this time and therefore, the fiscal deficit will be reasonably close to the target set in the Budget and of this about 50 per cent will be absorbed by the Reserve Bank. Then, once the global inflation settles down, I think the market will gradually reconcile to the fiscal deficit and that should not be a big challenge, going forward.

Where do you think government bond yields are headed from here on (rough levels) and why? Can you comment on what is expected with respect to the shorter and the longer end of the yield curve?

Right now, the 10-year g-sec yield is around 6.1 per cent, I think it will move to 6.30 per cent in the next three months. And then towards the end of the year (last quarter), it will get close to 6.5 per cent. Beyond that I don’t see any significant movement in the 10-year yield.

A steeper yield curve is a classic bond market move that happens when the expectations of the central bank tightening begin to firm up. While the long end moves up much faster the shorter end is also a function of the liquidity in the system whereas the long end is more of macro fundamentals, So, the shorter end tends to move up more than the long end over a period of time, and therefore the curve will flatten.

Is there a possibility of greater volatility in the bond market once the US Fed (rate hikes possible in 2023) and other central banks begin monetary tightening?

Apart from the Fed, there is no other central bank which is looking to tighten and the Fed too has been largely tolerant of high inflation. Inflation is possibly showing signs of topping out. I mean, rate hikes in 2022 or 2023 is a long way off and things can change. So, if inflation stabilises, the risk of rate hike will cool off. I think the kind of taper tantrum in 2013 is unlikely to be repeated. This is because of two reasons. One, the Fed will not act as there is still a lot of uncertainty and there is a lot more than just the fear of inflation.

Two, this time, the taper tantrum doesn’t mean that they will start withdrawing liquidity, only the incremental flow will slow down and the rate hikes may still happen in 2022/23. But we still have a long way to go and I don’t see a big reaction from any of the major central banks.

What funds should debt fund investors choose, given the current conditions? Should they consider taking credit risk?

One is low-duration funds where the average duration is generally about one year. So, when the debt papers mature in the next six to nine months, even if the rates go up, bonds will revert to value. Two, short-term funds are looking good because here the duration is 1-3 years and because the curve is very steep, the carry is good. Five-year bonds are offering 5.70-5.75 per cent and that is a reasonable spread.

The fact that AAA and AA spreads are coming down and not those on the lower-rated bonds shows the market preference for the higher-rated bonds. Taking credit risk is never a good idea. Whenever the situation tightens, poor-rated companies suffer the most. If people are expecting rates to go up and the liquidity to tighten, then I don’t think credit risk is a good idea. Moderate amount of shorter-maturity credit up to AA- is okay. But longer-duration credit risk should be avoided.

Published on July 24, 2021

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