By: Punam Sharma
The Changing Shape of Our Yield Curve
We have seen a substantial change in the shape of the yield curve over the last one year or so. To recap, the curve had been very flat in the few years leading up to 2014. For the first phase of this period this was largely owing to strong statutory bidding interest, not least from the RBI itself which used to create the bulk of reserve money from buying government bonds in the market. Indeed the quantum of RBI purchases per financial year used to be in the INR 125,000 – 150,000 crores range in that period. Then in mid- 2013 there was an emergency effective reset taken on the overnight rate as a means to avert a potential funding crisis triggered by the Fed’s taper tantrum. This kept the yield curve flat to inverted for a while. Then as the emergency measures were slowly unwound some steepness started returning to the curve. However from mid 2014, as India’s macro started getting re-priced with sharply falling inflation and lower deficits, the back end of the curve rallied strongly; thereby again flattening to mildly inverting the curve at end of the year.
Since 2015 when the actual RBI rate cuts started, the curve started to steepen again. This happened as the front end rates reflected the lower funding costs whereas the back end remained anchored on adverse demand – supply dynamics. Towards end 2015 / beginning 2016 the trend has got further accelerated owing to visibly muted appetite at the long end of the curve. This is because of higher supply of state loans and bank bonds with some overhang also owing to the potential additional supply ahead on account of the ‘UDAY’ bonds under the new proposed power discom restructuring package.
In our view, there are 3 dominant themes that fixed income investors should be aware of in the time ahead. These themes, and potential shifts in them, should determine sources of performance in bonds. These are explained below:
1. The potential for crowding out
The chart below tracks how the gross supply of centre and state bonds has been rising over the past few years. The noteworthy thing here is how the supply of state development loans (SDLs) has been rising, and especially so in the current financial year. Since both count as SLR bonds, both need to be considered when assessing appetite in the market. Additionally, SDLs compete directly with the long end of the curve since the demand set for both these bonds is the traditional ‘investor’ community (insurance and provident funds). Banks also like SDLs since there is some valuation buffer that they derive out of it. It is to be noted that this rise in SDL supply is happening simultaneously as the government is elongating the average maturity of the bonds that it issues. This is because owing to having issued shorter maturities in earlier years, the government is saddled with large maturities of its bonds over the next few years (between INR 225,000 crs to INR 300,000 crores in each of the next few financial years). Hence issuing shorter maturity bonds would further increase the maturities due in these years which any prudent debt management should avoid. As a combined result of larger SDL issuances and longer government bond supply, the supply of ‘duration’ securities has increased markedly over the past couple of years.
The problem is that this phenomenon is expected to get worse in the year ahead. This is because the total maturities of government bonds in FY 17 is almost INR 80,000 crores higher than in FY16. This means that even if the net government borrowing is the same as this year, the gross supply will be higher by INR 80,000 crores. This matters since when the appetite for duration is already weak, market participants may not want to replace bonds maturing in their books with long tenor bonds. All told, the total gross supply (including government bonds and SDLs) is likely to be around INR 10,00,000 crores in the year ahead. Of course, any bond switches that happen in the rest of the current financial year will reduce this number. However, the reduction is unlikely to be very meaningful. It is to be noted that this estimate doesn’t assume any meaningful fiscal slippage. Also UDAY bonds, if and when they come, will be over and above this number. A key take-away from this analysis is this: If the government keeps to its deficit targets, it may induce RBI to cut rates one more time. However, even at the desired deficit target levels the supply of duration bonds is large enough that they are unlikely to react meaningfully to a rate cut. The reaction is likely to be more pronounced in front end bonds which don’t suffer from this supply pressure. On this point, it should be noted that only around 10 – 15% of this gross number is in 7 – 8 year bonds and there is no supply whatsoever in bonds below that maturity.
Another source of crowding out may inadvertently be owing to government’s efforts to tap into all available local savings pools in order to further infrastructure financing. As an example, LIC has tied up with railways to provide INR 150,000 crores of funding over a period of 5 years. While the merits of such an exercise are beyond doubt from the perspective of creating India’s infrastructure, from the limited perspective of the current discussion it does divert INR 30,000 crores a year of of LIC’s bond demand from the market. In a similar vein, the plethora of tax free bonds being allowed are channeling savings away from bank deposits and hence away from SLR demand (banks would have in part bought SLR against those deposits). As a third example, a steep bank recapitalization ask is ensuring a robust supply of bank bonds (tier 1 and 2s) in the market. Since the ultimate investor base is constant, demand that gets diverted to these bonds would have otherwise gone into other market securities.
Hence, theme 1 is that crowding out is a real and present danger for bond market performance. Therefore, performance is likely to continue to come from those segments of the bond curve where this phenomenon doesn’t exist.
2. Weaker forward interest rate expectation
The year 2015 was somewhat of a ‘blue sky’ scenario for Indian macro. That is to say that our macro had a large rerating in context of a progressively weakening global environment. Inflation was well on its way into a downward trajectory, halving from earlier averages of 10%. In this context, it was anybody’s guess as to how many rate cuts the RBI could deliver and how low yields could fall. Indeed, as it turned out the RBI delivered a hefty125 bps rate cut during the year.
Given that the forward interest rate expectation loop of the market was reasonably strong in 2015, and was continuously getting reaffirmed by actual actions by the central banker, there was still reasonable appetite for duration. It is another matter that the bond supply dynamics (as discussed above) were strong enough to overwhelm even this appetite. In contrast to that scenario, we are starting 2016 with most participants expecting at best another 50 bps of rate cuts before the cycle troughs out. Hence the forward interest rate expectation of the market is nowhere as strong as it potentially was over most of last year. Indeed, the RBI itself has cautioned in the policy just gone by that we should focus more on macro stability via continually managing our inflation and deficits, rather than let aggressive growth ambitions create macro instabilities down the road. Both India and the world have seen plenty examples of this policy error. Furthermore, there are risks that can potentially further dent even the market’s current modest interest rate cut expectations. Thus for instance, if the months ahead throw up a sizeable urban consumption stimulus (from pay commission) and a meaningful rise in rural wages (much required and quite urgently from a basic welfare perspective), then the market may need to further reassess its expectations. In such a discussion, one also has to be aware of the marginal utility of an incremental rate cut. Banks have been unable to pass on previous rate cuts fully both owing to asset quality provisioning as well as because deposits are not immediately forthcoming at a much lower deposit rate. While some additional transmission should happen post general adoption of the new marginal cost of funds formula, an underlying point remains: Aggressive rate cut enthusiasts often forget to look at the liability side of the picture. We haven’t really broken much new ground in shoring up our domestic savings to GDP. Indeed, the dramatic fall in our current account owes mostly to a collapse in investment to GDP rather than a rise in savings. If that is the case, then any cyclical revival in demand for funds will put new pressures on funding. Furthermore, given global volatility and in absence of further improvements in our inflation and productivity, we need to maintain an adequate risk spread on Indian assets for the fund flow to remain alive meaningfully.
Thus, theme 2 is that with a more modest forward interest rate expectation of the market, the appetite for duration assets will likely be weaker. Therefore, performance may be more assured from trades that don’t rely heavily on further rate cuts from the RBI.
3. The scope for roll down
As elaborated upon above, for most part of the past few years we have seen a flat to inverted yield curve. Therefore, there were only 2 types of trades that the curve allowed for: either be long duration and benefit if yields fell; or be in very short paper for the modest ‘carry’ that it afforded over the overnight rate. However, over 2015 the steepness on the curve between overnight and 5 year rates has risen appreciably. This is allowing for a 3rd kind of strategy: that of roll down. So not only is there a large carry to be had over the overnight rate by being in ‘front end’ assets but there is a strong opportunity for ‘roll down’ as well. As an illustration, the difference between 3.5 years and 4.5 years government bond is almost 15 bps. Hence, in one year’s time, when the current 4.5 year bond becomes 3.5 year maturity, its yield will automatically fall by 15 bps; even if interest rates generally don’t move at all. It is to be noted that this strategy is not dependent on future rate cuts from the RBI. So even if the market’s forward rate expectation loop remains weak, and indeed the RBI disappoints with further rate cuts, the roll down strategy will pay off so long as the 1 year rates are well anchored. This we are positive the RBI will ensure. In fact there is a visible pushback lately on the central bank’s liquidity management strategy which, it can be argued, is keeping overnight rates unduly volatile. In fact the Governor has promised the market that the RBI is relooking at its liquidity strategy. Should some changes occur here in order to better anchor call and treasury bill rates to the overnight repo, it will further benefit the roll down trade.
Hence, theme 3 is that the yield curve is providing an opportunity for roll down trades for the first time in recent history. This trade is not dependent on further rate cuts and asks only that the RBI anchors overnight and very short term rates towards the repo. If rate cuts happen then transmission will first happen in short end rates as we saw most of last year.
Risks to the Themes
1. Should the supply-demand dynamics at the back end of the yield curve change sustainably, then performance can come back to that sector of the yield curve. However, we would assign a very low probability to this. As discussed above, even if the government sticks to 3.5% deficit target and the UDAY bonds are absent from the market, the dynamic doesn’t change sustainably. Of course, if these were to happen there may be a relief rally at the back end. However, it is unlikely to sustain.
2. If the market’s forward interest rate cut expectations were to get more aggressive than currently, that may re-ignite interest at the back end of the yield curve thereby supporting the duration trade. The most likely way this could happen is if global growth prospects deteriorate significantly and the market starts anticipating that the RBI will have to respond to the consequent impact on our local economy. While if the scale of global collapse is big enough this may certainly turn out to be true, we would caution on 2 aspects: One, if the government were to respond to such a crisis via a fiscal expansion (could be inadvertent as well if revenues collapse) which leads to even higher market borrowing; then the back end of the curve will continue underperforming. Two, and this is with respect to forming aggressive interest rate cut expectations themselves , RBI will have to balance the incremental rate cut’s marginal utility to stimulate growth versus the potential for further denting savings flow. This is true since the same logic that stood at 8% repo can no longer be applied at 6.75%. Also, the mandate to shore up funds flow will be especially acute if global risk aversion picks up. This consideration may also constrain RBI from responding very aggressively to potential global adversity from here on.
Investors have been justifiably frustrated over the inability of duration to perform in the face of rate cuts last year. In fact the trade has become downright painful over the past couple of months or so. The themes highlighted here put context to what has been happening. Furthermore, if they were to continue (as we think they would) then broadly long duration may continue underperforming in the time ahead as well. The larger idea behind describing these themes is that they point towards where performance may still be forthcoming on the bond curve. It is also important to recognize that there will always be counter-trend moves to the underlying theme. Thus for instance, short term rallies at the long end should be expected from time to time; especially as the extent of reset over the past few months has been quite sizeable. However, any investment strategy that investors (or funds) align to has to be the durable underlying trend. This we believe will be dictated by the themes presented above. In line with this, we have already aligned our bond and gilt funds around the themes mentioned here. Should one or more risk factors mentioned here emerge meaningfully, then we would reconsider our strategy as well.