Posted On Friday, Oct 07, 2022
The bond market started on a positive note in September with the 10-year Gsec (Indian Government Bond) yield dipping below 7.10% for a brief period on an expectation that Indian government bonds would become part of the global bond index.
But the momentum couldn’t last long. Rising global yields, higher-than-expected domestic inflation, tighter liquidity conditions, and a hawkish monetary policy by the RBI pushed bond yields higher by the month's end.
The 10-year Gsec closed the month 21 basis points higher at 7.40% on September 30, 2022, as against closing of 7.19% on August 31, 2022. The impact was more pronounced at the shorter end of the yield curve as 1-5 year bond yields moved up by 30-50 basis points during the month.
Central banks in advanced economies intensified their inflation fight. The US Fed hiked by another 75 basis points in September pushing up the Fed Funds rate range to 3.00%-3.25%. European central bank (ECB) also hiked by 75 basis points, while the Bank of England raised the policy rate by 50 basis points in the month.
The Monetary Policy Committee of the RBI in its bi-monthly policy on September 30, 2022, hiked the policy repo rate by another 50 basis points from 5.40% to 5.90%. It maintained the policy stance as ‘withdrawal of accommodation’.
Justifying the ‘withdrawal of accommodation’ stance, the RBI Governor mentioned that overall conditions are far more accommodative compared with 2019 when the repo rate was at 5.75% and projected inflation was 3.4-3.7%. The current repo rate is 5.9% and the projected inflation is 6%.
This indicates that the real repo rate (repo rate minus expected inflation) is back on the RBI’s radar and they would hike the repo rate to above-expected inflation levels. The bond market is now pricing for the repo rate to peak at 6.5% by end of this year.
Declining banking system liquidity over the last few months has put upward pressure on short-term money market rates. RBI, in its commentary, seems comfortable with prevailing liquidity conditions and there was no indication of durable liquidity infusion at this stage. This keeps the OMO purchases of bonds out of the picture for now.
The RBI guided to keep the banking system liquidity near neutral through variable rate repo and reverse repo operations. This should support the short-term bonds though longer-tenor bonds may face some pressure in absence of OMO purchases by the RBI.
With elevated global and domestic inflation, synchronised monetary policy tightening in advanced economies, and adverse demand-supply dynamics in the domestic bond market, the macro backdrop is not supportive for bonds.
However, the positive side is that much of the macro worsening has already happened and it is now part of the collective market psyche. We have already seen the worst of inflation. Much of the rate hikes have already happened. The peak of central banks’ hawkishness is now behind us.
Looking forward, inflation momentum is expected to fade. The rate hiking cycle is nearing its end. This should bode well for bonds.
After the recent sell-off, the bond market has already built in a significant uncertainty premium. Currently, the 3-year government bond is trading at a yield of 7.3%. This is 140 basis points above the repo rate of 5.9%. The long-term average of this spread in a tightening interest rate environment is around 80 basis points.
As the monetary policy stabilises, the yield spread between long-term bonds and the repo rate should compress. So, we see limited upside on yields from here.
We expect bond yields to move sideways in a tight range with the 10-year G-sec yield trading between 7.2%-7.6%. While Short term money market rates will move higher along with the policy repo rate.
Considering the duration-accrual balance, the 3-5 year segment remains the best play as core portfolio allocation. However, valuation at the longer end bonds up to 10 years have also turned attractive after the recent sell-off.
We suggest investors with a 2-3 years holding period should consider adding their allocation to dynamic bond funds to benefit from higher yields on medium to long-term bonds.
Dynamic bond funds have the flexibility to change the portfolio positioning as per the evolving market conditions. This makes dynamic bond funds better suited for long-term investors in this volatile macro environment.
Investors with shorter investment horizons and low-risk appetite should stick with liquid funds. With the increase in short-term interest rates, we should expect further improvement in potential returns from investments in liquid going forward.
Since the interest rate on bank saving accounts are not likely to increase quickly while the returns from the liquid fund are already seeing an increase, investing in liquid funds looks more attractive for your surplus funds.
Investors with a short-term investment horizon and with little desire to take risks should invest in liquid funds which own government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default.
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