Suyash Choudhary

The secretary Department of Economic Affairs (DEA), Subhash Garg, is now associated as the face of the government when it comes to all things to do with borrowing. It was thus the DEA secretary who announced the H1 borrowing calendar this week, an announcement that has collapsed 10 year yields by 30 bps overnight. To be truthful, the recent experience with respect to borrowing announcements has been less than pleasant. Thus one would remember how in September, the H2 program was ‘front loaded’ in order to make space for higher borrowing if required. While this was done prudently and truthfully, it did serve to create lingering uncertainty in the mind of the market. Then in December, the borrowing announcement actualized the market’s worst fears with a much higher than anticipated extra borrowing number; only for this number to be revised lower very shortly afterwards. Finally, the residual auctions over January – February were also conducted in a somewhat ad-hoc fashion with supply getting loaded in the so-called belly of the curve where the pain to the market was maximum. Given this backdrop, and with the borrowing number considered a hard truth, one was still wary on what to expect entering the latest announcement on H1 FY19 borrowing.

 

To say that the finance ministry outdid itself, would be a fair assessment. The first staggering item was to actually cut the gross borrowing program announced in the budget for INR 6,06,000 crores by a full INR 50,000 crores. This was done by reducing the intended buyback by INR 25,000 crores and relying on small savings for an additional INR 25,000 crores. Further, even of the reduced calendar for INR 5,56,000 crores for the full year, the government is choosing to borrow only 52% in the first half; versus the 60 – 65% that should normally be the case. Not just this, and despite refinancing pressures in the near few years, the ‘belly’ supply (10 to 14 years) has been cut to less than 30% of the auction. Instead, the longest end has been slightly increased whereas a new bucket for 1 – 4 years has been created for around 8% of the auction. There is also a commitment made that the government will come out with a separate switching calendar to allow investors to sell back their illiquid securities to the government.
 

In total, this is a very sizeable adjustment and the 30 bps rally in the 10 year should also be looked at in context of the counterfactual: that if adjustments hadn’t been made to the calendar, the 10 year would have probably gone towards 8% eventually. Instead we are at 7.30% at the time of writing. The ‘Garg Put’, named somewhat flippantly here since the decision is organizational and not of one person, is thus quite real and meaningful.

 

Assessment
 

The following points are immediately noteworthy, in our view:
 

1. It is remarkable, and not known in recent memory, that the borrowing number gets tweaked from what gets mentioned in the Union Budget. It reminds one of the decision to announce INR 50,000 crore of extra borrowing in late December last year, only to revise it to INR 20,000 crores by mid of January. These tend to cause undue volatility in the market where the analysis of fundamental factors almost becomes secondary. It is to be hoped that one doesn’t see as much of such event based volatility in the time ahead, as one has seen over the past few months.
 
2. The reduced borrowing size doesn’t leave much room to accommodate fiscal uncertainties down the road. The biggest one here is with respect to Goods and Services Tax (GST) collections. So far, the monthly run rate is well below par and in fact has dipped over the past few months. There is an expectation that this picks up post implementation of the e-way bill. This now needs to happen for sure, else worries around higher borrowing will resurface by mid-year. This may be more worrisome now since the government is anyway scheduled to borrow almost half of the current program in the second half. There are two additional factors to consider here: One, it is possible that the RBI provides an offset by buying bonds under Open Market Operations (OMO), given our view that core liquidity will likely turn negative towards second half. Two, market’s RBI policy rate expectation will play a part here as well. Should we have a normal monsoon, the Minimum Support Prices (MSPs) don’t pose a large risk to Consumer Price Index (CPI), and the cyclical local recovery doesn’t start picking up further (along with usual caveats of oil, USD, etc.), then the environment may remain conducive for absorbing the supply. However, should expectations change by then, then the higher H2 supply may start posing a challenge; especially if yield levels are no longer as adjusted owing to a bullish surprise in H1.
 
3. Prima facie the decision to ‘front-end’ borrowing more will cause refinancing pressures down the line, given the higher maturities lined up over the next few years and the reluctance to do as many bond switches by the government. This could be another instance of ‘can down the road’, alongside pushing more borrowing into H2 in the current year. Equally, however, it is possible that the government will now undertake more bilateral switches (with RBI, LIC, etc.) where it switches shorter maturity bonds to longer maturity ones directly with the counterparty.
 

Implications
 
The revised auction calendar has had the immediate effect of significantly bull flattening the yield curve. This is logical since the greatest feared supply risk was in the belly of the curve, which isn’t the case anymore. However, it is a stretch probably to expect this outperformance to continue. The revised borrowing calendar in a sense reflects the new market reality; that there simply isn’t enough appetite left for longer tenor bonds in the general market (one isn’t referring here to the longest end which is the domain of insurers and provident funds largely). Thus it is likely that banks’ also run shorter maturities in their non-held to maturity (HTM) books. Also foreign portfolio investors (FPIs) typically prefer shorter maturities as well. Even from a value standpoint, the difference between 1 year treasury bill and 4 year government bond yield is now 80 bps. Whereas 4 year to old 10 year bond is less than 20 bps. Such a shape of the curve would make sense if RBI policy expectations were sanguine. While we don’t expect a near term hike as discussed here many times before, it is equally true that most would imagine that the next move whenever is a hike rather than a cut. Thus, the longer duration / belly trade has to be looked at as tactical at best and core portfolio strategies must be aligned towards the front end, in our view.

 

Investor Takeaways
 
From a steady state perspective, pure front end strategies like ultra-short / short term / medium term funds continue to make imminent sense. AAA / sovereign rates have adjusted the most over the past few months versus lower rated, high yield credit; thereby making AAA / sovereign as well as relatively liquid ‘mid-yield’ credits much more attractive. Also, portfolio yields for such products are still only 20 – 30 bps lower than the extreme top that they had achieved in the past few months. With general interest in the market being stronger after the new auction calendar, the effect should also rub-off on front end rates. Not just that, seasonality favors the trade as well since typically liquidity conditions get better and incremental credit to deposit ratio falls over April – June; thereby benefiting front end rates. Our active duration bond funds have core long positions in up to 5 year rates and we are preferring proxies like corporate bonds, State Development Loans (SDLs) and higher carry government bonds in the 10-year segment.

 

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