By: Punam Sharma
There are two strong sets of dynamics to the bond market today. These are described below:
1. Weak Growth: Prospects for global growth have continued to deteriorate with ample signs that the manufacturing / investment cycle in most parts of the world is deteriorating sharply. This is readily visible in a wide array of commodity prices most chiefly in items like oil and metals. The deterioration in global growth is impacting India’s prospects as well, most directly via a collapse in total trade. Additionally, banking credit growth remains weak and so does private sector investments.
2. Strong External Stability: In an environment of weak global growth and credit concerns, there are many emerging markets (EM) that are facing significant external vulnerabilities. This has put pressure on currency and hence interest rates in these countries. In stark contrast, India now runs a positive basic balance (current account deficit plus net foreign direct investment). This, alongside stable public policy, has enabled us to cut interest rates in an environment of considerable global uncertainty. The same dynamic is likely to persist in the time ahead as well.
3. Proactive Government Policy: The government has shown a strong commitment to both fiscal consolidation as well as food supply side management. Alongside the effect of crashing global commodity prices, this discipline has helped break the back of India’s structural inflation. Despite considerable political pressure, the government has also so far resisted taking the consumption stimulus route; instead focusing on rebalancing spending into investments. This has both a stronger future growth multiplier as well as is relatively non-inflationary.
4. Accommodative Monetary Stance: Against all expectations, the RBI has delivered 125 bps rate cut in the calendar year 2015. It has also stated that the stance of policy remains accommodative and the central bank will look for more emerging room to cut rates. In terms of the three pillars of RBI policy – rates, communication, and liquidity- it has already plugged the first two. Thus not only has the central bank cut rates, it is also sounding much more dovish than it was right up till mid-year. At some juncture if it chooses to modify its liquidity stance as well, then that would be extremely bullish for interest rates.
A clear takeaway from an assessment of the macro factors is that bonds remain a very strong asset allocation story. This also means that despite recent fatigue, it is inadvisable for investors to take ‘cash calls’ on their bond investments.
Despite the underlying story, the frustration felt this year has been quite real. This has spanned investors and traders alike as the mid to long end of the yield curve has largely refused to budge despite the hefty rate cuts. However, two points bear mentioning here:
1. The mid to long end of the yield curve performed extremely well when it rallied 100 bps from 9% to 8% in response to CPI almost halving and in anticipation of future rate cuts from RBI. Hence over a 1.5 year period starting from mid 2014, the mid to long end has done extremely well. It’s just that its performance has been front loaded over the first 6 months of this period.
2. Even during the period of non performance of the mid to long end of the curve (over this calendar year), it is not as if there has been no performance on the bond curve. As is clear from the graph below, from virtually a fully flat curve at the start of the year, the yield curve has steepened somewhat has the short end has responded to the RBI rate cuts while the long end has been held back.
The ‘blue’ curve above is the latest sovereign curve whereas the ‘red’ is the curve as at 1st January 2015. While yields have actually risen for the 15 years and beyond segment, they have fallen for shorter tenors. There have been technical factors at play that have led to the under-performance of the mid to long end of the curve. Most simply put, there has been a mismatch in demand versus supply of bonds in these tenors. Some of these technical factors are summarized below:
1. Banks have traditionally been the strongest anchor investor class for bonds. Indeed, given the current environment where there is a ‘positive wedge’ between deposit growth and credit growth, they have been running an excess SLR book amounting to 6 – 7% of their deposit books. However, what has hurt appetite on the margin is the fact that all the excess SLR has to be held outside the so called ‘held to maturity’ book and is therefore subject to mark to market. Thus even though banks may have the capability to buy, incremental appetite has been at least partially hurt because bond investments have turned loss making. In an environment where there is anyway a tall ask on their risk capital owing to rising credit costs, their appetite for incremental losses on their investment books as well would be quite limited.
2. Traders including banks and primary dealerships are broadly suffering a similar dynamic. Appetite for incremental loss taking is limited given constraints on risk capital and hence position sizes in the market have progressively been marked down. This section of the market has been an important swing player both to match the demand versus supply equation as well as in creating momentum in prices. This is largely absent now.
3. Provident fund (PF) and insurance companies remain consistent buyers. However, here as well there are 2 additional factors of note: One, supply of state loans (SDL) that are available at a decent spread over government bonds is higher by about INR 35,000 – 40,000 crores in the current year which is helping satiate PF and insurance demand and hence weakening the bidding in longer end government bonds. Two, LIC is also contributing debt funding to Indian Railways to the tune of INR 150,000 crores over the next few years. If not for this, this money would have gone into bonds.
4. RBI used to be a net buyer of government bonds to the tune of INR 125,000 – 150,000 crores during the 3 years prior to FY 15. This used to provide a significant boost to bond demand. However, since last year it has turned a net seller as most of reserve money creation has been happening through accretion of forex assets rather than the central bank having to buy bonds from the market. This is also an important change as far as the demand versus supply equation is concerned.
5. Foreign portfolio investors (FPIs) are no longer the important swing factor that they used to be earlier. This is because the RBI is allowing gradual increases in their participation over a longer period of time. Hence while they may still constitute an important source of demand when the next couple of years are considered in total, their incremental participation per quarter no longer changes the demand versus supply equation meaningfully.
Looking ahead, most of these technical factors may continue to persist for the mid to long end of the curve. In fact there are a few additional factors that may pose as additional causes for concern. These are:
1. The new discom restructuring package (UDAY) envisages interest saving for power discoms by replacing a large portion of high cost loans provided by the banking system into lower yield bonds issued by state governments. Approximately INR 4.3 lakh crores worth of loans may be affected by the package, a significant portion of which may eventually get converted into state government bonds. This will depend on how many states eventually decide to take part in this voluntary scheme. Once the bonds are created they may constitute an additional source of supply over a period of time.
2. The total government bonds maturing in the next financial year are around INR 225,000 crores versus INR 145,000 crores in the current year. This number may go down somewhat after the current year’s bond switch are executed. Nevertheless, gross bond supply in the next financial year will be higher from this year by a significant margin purely on account of these maturities, even if net borrowing remains exactly the same. Since most of the issuances happen at the mid to long end of the curve, these bonds may face additional pressure on account of the higher gross supply.
It must be understood that RBI can still step in and balance the demand versus supply equation via purchasing bonds from the market. The justification for this can be sought either from perspective of reserve money creation (since forex asset accretion has again slowed down lately) or from ensuring that sustained transmission of previous rate cuts happens (since banks cannot continue transmitting if risk free curve refuses to budge). If this were to happen in a significant way then it can completely alter the demand-supply dynamic for the mid to long end of the curve and refocus market attention to this segment. However, pending such an action we think there is a strong likelihood that, for the reasons mentioned above, the steepening bias in the yield curve persists. It must also be noted that even though the yield curve has steepened relative to what it was a year back, it still remains reasonably flat. The long end yields have risen not just because of natural steepening tendency but also because volumes there are low and hence market is now attributing a higher illiquidity discount to those bonds. Adjusted for this, the steepness between an 8 and a 25 year bond is only about 15 bps. The true steepness on the curve is between the overnight at 6.75% and the 5 – 9 year segment which is more than 100 bps higher on an average.
The following summary points need to be highlighted from above:
1. The mid to long end of the curve performed strongly in the first phase of India’s macro adjustment. For the last year, even though the environment has remained conducive for technical reasons this part of the curve has stopped performing.
2. Performance has moved to the ‘front’ part of the curve (loosely defined as 0 to 8 years) where the steepness versus overnight is maximum and the technical factors plaguing the mid to long end are largely absent. This is because the government no longer borrows in 5 year bonds whereas supply in the 6 – 9 year segment is also only around 20% of total supply. Additionally, there is a very clear ‘roll down’ visible in this sector. As an example the 5 year sovereign bond is at 7.70% whereas the 3 year is at 7.50%. Thus even if the yield curve remains static, the yield on the current 5 year will fall by 20 bps over the next 2 years. This is what is meant by roll down.
3. The macro reasons to remain engaged in interest rates is very strong. Hence, we would strongly discourage investors from taking any ‘cash calls’.
Respecting the above dynamics, and in line with our active managed stance across the platform, we have moved a majority exposure in our bond and gilt funds from the mid to long segment into the 5 – 9 year segment. This trade has already worked well over the past month as the yield curve has continued steepening. For the reasons mentioned above, we think that going forward and especially into the new financial year, the yield curve may steepen further. This means that the 5 – 9 year sector may continue to be the performance driver for the foreseeable future; barring of course incremental action from the RBI to stem the demand supply mismatch at the mid to long end sector of the curve.
In conclusion then, in an overall supportive macro environment for rates, we believe that performance drivers have shifted further to the front of the yield curve. We are accordingly positioning our bond and gilt products to benefit from this phenomenon. Investors need to do nothing but continue to look at these products from an asset allocation perspective.
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