By: Punam Sharma
Just ‘Coz You See It (Doesn’t Mean It’s There): A Bond Update
We’ve been aligned to the idea of a steepening yield curve for some time now. Our chief reasons behind the expectation have been 2 fold: limited incremental visibility of rate cuts, and higher aggregate duration bond supply (including GOI, states, UDAY). This thesis has been tested at points of time during the last year; most particularly when RBI suddenly shifted its liquidity stance and unleashed large-scale bond purchases from the market (thereby challenging our bond supply assumption). However, through temporary disruptions like this and other events (Rexit and Brexit being other notable ones), the underlying trend of curve steepening has remained intact. It has accelerated markedly since September as, presumably, more participants started seeing the prospects of limited incremental rate cuts.
While causal commentary on bonds may restrict itself to movements in the 10 year yield alone, it is instructive to see the full extent of the steepening phenomenon that has taken place over the past year or so. This is represented below as the yield differential between 2045 and 2020 government bonds. A portfolio strategy aligned at the right side of this phenomenon has benefited immensely over the past many months. And vice versa.
As can be seen in the chart, the 2045 to 2020 bond yield spread has moved from virtually zero in late 2015 to more than 100 bps now. The intermittent reversals seen in the trend have largely to do with the events described above: RBI’s aggressive bond purchases under its revised liquidity stance, and the period after Rexit / Brexit.
Yield curve steepening may be done for now
In our view, this dominant trend of yield curve steepening in play over the past year may be done for now. The explicit change in stance in policy stance flagged in the February RBI policy has virtually eliminated all residual rate cut expectations, thereby leading to an aggressive re-pricing of the duration part of the yield curve. Hence, it is likely that yields have largely adjusted to the reality of no further rate cuts from RBI. Also, aggregate bond supply has been higher largely owing to state and UDAY bonds. While we fully expect state bond supply to be higher than last year, seasonally supply on state loans picks up over October – March. This is presumably because the extent of state budget slippages only become apparent towards year end. Thus the next 6 months may be nowhere as busy on state loan supply as the 6 months (and especially the quarter) just gone by. Also crucially, the UDAY program was supposed to run till March 2017 and bond supply in this connection is mostly over. Hence, from the perspective of aggregate bond supply as well, the curve steepening theme is likely to take a breather. Finally, the global ‘reflation’ trade seems to be taking a pause as well. This is most notably getting demonstrated in incremental anchoring of US long end rates and fall in breakeven rates. If this were to continue, then it could constitute another reason for no incremental steepening of our own curve.
Risks to this view include an early resurgence in inflationary pressures either locally or globally. It must be also be noted that the view expressed here pertains only to the near forecasting horizon and some of the triggers mentioned here may indeed not hold later in the year.
In line with this view, and as highlighted in a recent note (please refer “Steady As She Goes : A Fixed Income Strategy Update”, dated 15th March, 2017), we have added duration in the 10 year segment largely via spread assets (state loans, UDAY, corporate bonds) in our bond and gilt funds. Most of these bonds have been bought at significantly higher yields than that on long end government bonds, and largely address the same investor class (insurance and provident funds) that the long end addresses.
Finally, it is to be noted that the lack of incremental steepening doesn’t imply that short term bonds stop performing or are not looking attractive. Rather, it means that the relative underperformance of the long end versus the short end may not be a sustainable theme any longer over the near foreseeable horizon. Indeed, 2 – 5 year corporate bonds have sold of significantly over March and currently provide attractive spreads over the RBI policy rate.
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