Posted On Saturday, Apr 11, 2020
April 11, 2020
Quantum Fixed Income Team
As the cases of COVID-19 (popularly known as Coronavirus) continue to increase at a dramatic pace, its impact on the economy and the financial markets became lot more pronounced in the last month. Nearly every central bank in advanced economies reduced interest rates to near zero or even below to keep the financial system going. Many central banks even turned into the lenders of last resort. Various governments also eased their fiscal policies and launched extensive stimulus measures to provide financial support to their citizens and to industry. Volatility spiked to historical levels in almost all financial markets across the globe.
In the local market, the yield (market interest rate) on the 10year benchmark government bond dropped briefly below 6.0% in the first week of March but sold off later to test 6.4% by mid-month owing to a global risk off sentiment and large selling by foreign investors. During the same time, impact was much more severe on the corporate bonds and the money markets (certificate of deposits and commercial papers). Even good quality AAA rated PSU and Private Sector bonds witnessed large sell-off with yields of these bonds increasing by 100-150 basis points (1.0-1.5%) across tenors. The Yield on 1 month to 1year money market instruments like Certificate of Deposits and Commercial Papers also moved up by over 200 basis points leading to even liquid funds posting negative returns for a brief period.
To ease the visible stress in the bond and money markets, the RBI first infused a lot of liquidity into the banking system through Long Term Repos (LTROs - RBI lending to banks at the Repo Rate for 1 year and 3 years) and later through Open Market Operations (OMO - RBI buying government bonds from the market and infusing Rupee liquidity). But these measures failed to enthuse the markets in any material way.
Later in the month, in a water-shed monetary policy the RBI announced a much bolder and comprehensive monetary package comprising large rate cuts, liquidity infusion and regulatory relaxations to reinforce financial stability and to support the economy.
They reduced the repo rate by 75bps and the reverse repo rate by 90 basis points to 4.40% and 4.00% respectively. The RBI also took various measures ranging from reducing the Cash Reserve Ratio (cash reserve which banks have to maintain with the RBI) by 100 basis points to 3% of NDTL (Net demand and time liabilities of bank) for 1 year period and increasing the bank’s borrowing limits under the Marginal Standing Facility from 2% to 3% of NDTL.
The most significant was the announcement of Targeted Long Term Repo Operation (T-LTRO) for commercial papers and corporate bonds under which banks can borrow from the RBI for 3 years at variable repo rate (Currently at 4.4%) and invest into commercial papers or corporate bonds upto 3year maturity.
This led to a sharp decline in market yields of high rated corporate bonds and commercial papers. Yield on short maturity (2-5 years) corporate bonds which had risen earlier in the month dropped by more than 100 basis points as 5year AAA rated PSU yield fell from ~7.5% to 6.3%; while yield on 2-3 months commercial papers of PSUs fell by over 250 basis points from 7.7% to below 5.0%.
From here-on, the bond market will continue to be driven by mix of additional monetary and fiscal measures. There is a broader hope that the RBI will undertake more monetary easing (rate cuts, liquidity infusion etc.) to keep the financial markets calm and facilitate economic recovery. This should be supportive for the bond markets, especially the shorter tenure segments, which would likely benefit from the easy and surplus liquidity situation.
Despite this, the future trajectory of bond yields look highly uncertain as there are too many unknowns about this crisis and the government’s likely fiscal response. We don’t know for how long this lockdown will last and how much damage it would cost to the real economy. Nevertheless, it is almost certain that the government will need to enhance spending on healthcare to fight the virus and on providing livelihood support to millions of Indians at the bottom of the pyramid impacted by the lockdown.
The government recently announced a spending plan to provide free food, free gas, cash transfers and some others as part of welfare spending. However, given the scale of the problem, this fiscal package of Rs. 1.7 trillion (0.7% of GDP) looks grossly inadequate. It does suggest to us that more may be forthcoming and that the government is readying a ‘stimulus’ package for small business and industry as well.
Although, India needs to spend and not worry too much about fiscal deficit (government’s spending over its total revenue) in this crisis, but given that the Centre+State+PSU borrowing remains at ~9% of GDP, the scope for a US style fiscal stimulus of another 10% of GDP simply does not exist. We estimate fiscal spending to the tune of atleast 3% of GDP or roughly Rs. 6 trillion combined from central and state governments to tackle this crisis.
Increase in government spending and resultant rise in fiscal deficit means government’s borrowings from the bond markets would rise substantially which could put upward pressure on bond yields (downward pressure on bond prices).
The bond markets for now seem well supported by an all-encompassing RBI opening the liquidity spigot, cutting rates, allowing forbearance on EMIs and seeming ready to do more. At some time, there will be an ask of the RBI to support the government’s fiscal spending by buying government bonds directly from the government or indirectly from the market through open market operations (OMOs) and the RBI is likely to abide, which will further support the government bond markets and may prevent bond yields from rising despite higher government bond supply.
The problem though lies in the lower rated corporate bond segment which had already been under stress since the ILFS crisis of September 2018. With the uncertainty caused by Covid-19 and the lockdown, this problem of stressed companies and NBFCs has got further compounded. The Indian industry will likely face a serious cash flow problem during the lockdown and beyond due to the sudden fall in demand. Many individuals / small business and casual labours, who are leveraged may face a loss of income and this could lead to general deterioration in the credit profile and increase in credit defaults even on retail loans.Thus investors, especially debt fund investors need to apply extra caution while choosing debt funds. We advise investors to prefer safety and liquidity over returns in this environment rather than trying to earn higher returns from liquid, money market and bond funds.
Given the excess liquidity situation, which we expect to continue, returns from overnight and liquid funds will remain muted. However in the current uncertain times, investors should live with lower returns and should prioritize safety and liquidity over returns.
Thus we advise investors in bond funds to keep the market risks in mind while trying to benefit from any further fall in bond yields. Investors with low risk appetite should stick to short maturity funds or Liquid Funds to avoid any sharp volatility in their portfolio value. However, while choosing such funds one should be aware of the credit risk and prefer funds which take lower credit and liquidity risks.
We also advise investors in bond funds to have a longer time frame and keeping in mind that in the short term returns from bond funds may be volatile and may also be negative.
We once again like to reiterate that Quantum Liquid Fund (QLF) prioritizes safety and liquidity over returns and invests only in less than 91day maturity instruments issued by Government Securities, treasury bills and top rated PSUs.
Quantum Dynamic Bond Fund (QDBF) takes higher interest risks, but does not take any credit risks and is invested only in Government Securities, treasury bills and top rated PSU bonds.
In the current scenario, given the uncertainty, the portfolio of both the Quantum Liquid Fund and Quantum Dynamic Bond Fund will have a markedly higher proportion of government securities and treasury bills over AAA PSUs.
If you are someone who is extremely risk averse and do not wish to have the volatility and anxiety of market related instruments during this uncertain period, we would advise you to keep your surplus cash parked in a safe bank account.
Please also feel free to speak to your financial advisor or your relationship manager for any further queries and or advise.
Data Source: Bloomberg, RBI
|Name of the Scheme
|This product is suitable for investors who are seeking*
|Quantum Liquid Fund
An Open Ended Liquid Scheme
|• Income over the short term
•Investments in debt / money market instruments
Investors understand that their principal will be at Low risk
|Quantum Dynamic Bond Fund
An Open Ended Dynamic Debt Scheme Investing Across Duration
|• Regular income over short to medium term and capital appreciation
• Investment in Debt / Money Market Instruments / Government Securities
Investors understand that their principal will be at Moderate Risk
* Investors should consult their financial advisers if in doubt about whether the product is suitable for them.
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