An Early Diwali for Bond Markets

Posted On Friday, Oct 16, 2020

Governor Das’s policy announcements in support of the bond markets in March 2020 were termed as a bazooka. The announcements in the October monetary policy for the bond markets have enough to light up a few fireworks as well.

Chart – I : Bond Yields hinge on the Das PUT
Source – Bloomberg, Quantum Research
Past Performance May or May not sustained in Future

Last month, we spoke of the Das PUT – the expectation of RBI supporting the bond market whenever bond yields move up.

The Das PUT was visible with the RBI announcing OMOs, Twists, HTM relaxation to cap bond yields. They also tried the non-monetary signalling route by devolving the 10-year bond auction on underwriters thereby showcasing its displeasure to the level of the 10-year bond yield.

The 10-year benchmark bond yield had moved up sharply after the August monetary policy from the levels of ~5.8% to ~6.2%. RBI’s supportive measures have brought it down to about 5.9% now.

In the face of continued government bond supply and its uncertainty on the extent of the centre and state fiscal deficit, the longer end of the bond yield has remained high. The RBI is now moving its attention to try and address the yield curve. The Reverse repo rate is at 3.35%, the 5-year government bond is at 5.2%, the 10-year government bond is at 6.0% and the 30-year bond is at 6.8%. This as they call is a steep yield curve.

Orderly Yield Curve is a Public Good

With inflation well above its higher range of 6%, there isn’t scope to cut the policy repo and reverse repo rate. The RBI now has to use market instruments and moral suasion to get bond yields lower.

As per market demands, they have doubled the size of Open Market Operation (OMOs) to Rs. 200 billion per week. The RBI had been conducting operation twist/OMO of Rs. 100 billion every week since August 27, 2020.

Chart – II : ‘Yield Curve is a Public Good’
Source – Bloomberg, Quantum Research
Past Performance May or May not sustained in Future

Continuing its unprecedented actions, it has now announced OMOs in State Development Bonds. This is the first time, the RBI will manage the liquidity and the yields in the Quasi-Sovereign Space. Indian State finances are in an even dire situation than the Centre. However, States are at the frontline of the fight against COVID and to manage the economic recovery. States, having given up its rights on taxes after the introduction of the GST are now dependent on the Centre to provide them with the compensation of the loss in tax revenues. Anticipating the large increase in state government borrowing, the RBI is stepping into through OMOs to drive demand into the SDLs.

They have also used an age old monetary policy tool – Moral Suasion – asking market participants to believe in the RBI and support the government’s market borrowing and to not get into a combative mood.

“Financial Stability and orderly evolution of the Yield curve is a public Good” – the governor remarked.

Table – I : RBI’s actions to support bond markets
 Dec-18 till Feb-20Mar 20 till Oct 20
Rate CutsCut the Repo Rate by 135 bps (1.35%) from 6.5% to 5.15% from Oct 2018 till Feb 2020Cut Repo rate by 115 bps (1.15%) to 4.0% and Reverse Repo rate by 155 bps to 3.35%.
Move System Liquidity from Deficit to Surplus● OMOs of ~INR 3.1 trillion
● FX USD/INR Buy/Sell Swap of USD 10 bln
● Outright FX purchase of USD 70 Bln (~ INR 4.9 trillion)
Cash Reserve Ratio cut by 100 basis points of NDTL (~INR 1.4 trillion)
Change in LCR Ratios
Liquidity Surplus at INR 4 trillion
Manage long term bond yieldsConducted Operation Twists worth INR 400 bn whereby the RBI bought long term bonds and sold short maturity bondsOMOs of INR 700 bn
Operation Twist of INR 700 bn
Buying T-Bills under auction, Indirect monetization
Large increase in Government’s overdraft facilities
Increased HTM limit for Banks from 19.5% to 22% of NDTL
Commitment to conduct OMOs/Operation twist whenever needed
Increased the size of weekly OMOs
Drive through Monetary TransmissionLong Term Repo Operations (LTRO) by providing banks with 1 and 3 year upto INR 1 trillion at a fixed rateTargeted-LTRO of INR 1.5 trillion for buying corporate bonds & Commercial papers

On-tap TLTROs for onward lending to specified sectors

The markets, for now should respond favourably and bond yields across government bonds, State developments bonds and high rated corporate bonds should fall. Bond yield spreads between Government and State governments can narrow from its current levels.

Low for Long?

Governor Das’s ‘whatever it takes’ comment to support growth was likened to Mario Draghi, the ECB chairman’s similar refrain in 2012 to support the Euro.

The RBI has extended its “accommodative stance of monetary policy as long as necessary – at least during the current financial year and into the next year”.

The US FED gives out such guidance by saying – ‘Low for Long’ – that interest rates will remain low for long.

The RBI is attempting to give a longer guidance to the banks and the economy that they will keep interest rates low and maintain excess liquidity. This is however subject to CPI inflation. If inflation remains stubborn (see 2009-2011 period in chart below), the MPC may have to tighten liquidity and hike rates.

Chart – III : Inflation remains above RBI’s threshold
Source – Bloomberg, MOSPI, Quantum Research

What is Normal?

India entered COVID with below 5% GDP growth. When we talk about normalized GDP growth, what does it mean? 5%? 6%? 7%?

This Low for long on interest rates then depends on what RBI estimates normalized growth to be.

At Quantum, we estimate GDP growth for FY 22-25 to be well below its long-term potential of 6.5%. So, may be in a situation of low growth and higher than wanted inflation. This scenario will have implications for the bond market the economy.

Chart – IV : What is India’s Normal Growth Rate
Source – CMIE, Quantum Research

Tactical or Structural Trade

When the 10-year government bond yield moved below the 6% mark, we changed our bond market allocation outlook to tactical. We noted that Indian bond yields do not sustain below 6% for long.

We had also suggested investors to lower their return expectations from fixed income – as money market yields, fixed deposits will remain low and potential capital gains from long bond funds will be muted.

In our opinion, at this juncture investors should prefer dynamic bond funds over long duration bond funds. In Dynamic Bond Funds, fund managers have flexibility to change the portfolio duration (sensitivity of portfolio to interest rate movement) when their outlook on interest rate changes.

Chart – V : India yields do not sustain below 6% for long
Source – Bloomberg, Quantum Research
Past Performance May or May not sustained in Future

Because of the Das PUT, there may be tactical opportunities to trade in a range, which we also did when 10-year bond yields went towards 6.2%.

The RBI’s continued actions indicate their desire to see the 10-year bond yield even lower. We continue to see it as tactical trade opportunity in a broader range.

Why interest rates do not remain low for long in India?

Indian bond yields are at historic lows. Indian interest rates are near all-time lows. If you look at the 20-year chart of the Indian 10-year bond yield, the levels below 6% do not sustain for too long. The average during this period is 7.57%. This chart is also volatile and broadly ranges between 5% and 9%.

Between 2015 and 2019, when India followed Inflation targeting, the 10-year bond ranged between 6% and 8%.

In 2004 and 2009 look at the rise in yields once the bond yields touched all-time lows of about 5% yield. The yield rise in both cases was all the way up to 9% over a 4-year period. Such large up move in yields were negative for the bond returns on both the occasions.

Table – II : Bond Returns came down in periods after low rates
PeriodYield move
(10 year government
Bond)
Daily Average
10 year Gsec Yield
Annualized Bond Fund Return
Crisil Composite Bond Fund IndexCrisil Short Term Bond Fund IndexCrisil Liquid Fund Index
Oct 2003 - July 2008From 5.1% to 9.3%7.1%3.3%5.1%5.7%
Dec 2008 - Oct 2011From 5.2% to 8.9%7.6%4.8%6.2%5.9%
Source – Bloomberg, AMFI Portal, Quantum Research;
Table shows the annualized returns of debt fund indices during the rising yield cycles of 2003-2008 and 2008-2011. Data are taken on monthly closing basis to calculate the returns. This is shown only for illustration purpose.
Past Performance May or May not sustained in Future

2004-2008: the yield rise was primarily driven by higher growth and followed by a very late cycle inflation.
Overall a good outcome, as an asset allocation shift to equities would have managed the lower returns from fixed income.

2009-2013: the initial rise in yields was purely an outcome of the increase in fiscal deficit. The centre’s fiscal deficit exploded from 3% of GDP to 6%; while at the same time RBI had to catch up to the very high CPI inflation by aggressive rate hikes.
A bad outcome as fixed income returns fell, equities didn’t do well and we eventually ended up with a currency crisis.

We are not saying that this time will be the same. But it is important to understand the investing risks if it so happens. Also, it is important to understand what factors then drove the bond yields higher.

Chart – VI : Fiscal Deficit shoot up after 2008
(Source – CMIE, Quantum Research)

Fiscal Situation

In the current scenario, we have a large increase in fiscal deficit as the government responds to the economic impact of COVID-19. The trouble is that the fiscal deficit may stay high in FY 2022 as well.

Table – III : Government bonds supply to rise after COVID crisis
Government Market Borrowings
(INR Trillion)FY19FY20FY21EFY22E
Centre5.77.114.110.9
States4.86.48.18.0
Total10.513.522.218.9
% of GDP5.5%6.6%11.3%8.6%
Source – CMIE, Quantum Research
FY21 and FY22 borrowing numbers are as per Quantum Estimates

This year, the lack of growth and the risk aversion, has meant that banks have excess cash to buy government bonds. The bond market will face high supply of bonds next year at a time when the liquidity and credit conditions might not be as supportive. This could lead to higher longer tenor bond yields going ahead.

Don’t see a deep bond rally

The increase in our portfolio risk and maturity in the Quantum Dynamic Bond Fund is thus a tactical move. We are positioning for the Das PUT and the resultant stealth softening of bond yields. Given the objective of our fund stated in the name itself – we retain our right to remain dynamic in our portfolio construction as we though remain cognizant of these risks on the horizon.

We understand the economy and markets are currently adjusting to an unprecedented shock. There are too many moving parts and things are still evolving. Thus any forecast about future is susceptible to change based on policy responses from the government and the RBI and the changes in global markets. We stand vigilant to review our outlook as and when new information comes. Nevertheless, it would be prudent for investors to be conservative at times of heightened uncertainty.

Credit Crisis is not over yet

We reiterate our view that the credit crisis in the bond market is not over yet. The Indian economy has faced a severe jolt due to national lockdown. This has significantly weakened the debt servicing capacity of many companies and individuals. This could create a negative spiral in the economy and hence in the loan and bond markets. We may see risk of a higher amount of rating downgrades and defaults in the next two years.

In this scenario it would be prudent for investors to avoid excessive credit risk in their India debt exposure.


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