Debt monthly view for February 2020

March 11, 2020
Quantum Fixed Income Team

Bond markets had a solid positive run in February. The rally in bond prices (fall in bond yields) was first ignited by the government’s fiscal management in the budget by limiting the fiscal deficit to 3.5% of GDP and it’s announced intention of including Indian government bonds to be made part of a global bond index. The bond markets got further fuel from the RBI’s unconventional monetary easing through introduction of LTROs (long term repo operation). The RBI pledged to provide INR 1 trillion (one lakh crore) to the banks for 1 and 3 year period at a fixed repo rate. These two measures which are clearly positive from a bond demand perspective led to about a 30 bps fall in the 10 year Gsec yield from the mid-Jan peak of 6.7% to 6.4% post the RBI policy. The rally was more pronounced in the shorter maturity segment of the bond curve where yields eased by ~50 basis points from 6.4% to 5.9% on 4 year Gsec.

By the time domestic triggers got priced-in, focus shifted to the global developments as financial markets across the global started adjusting to the potential impact of the coronavirus. Oil prices in particular sharply corrected to fall below USD 50 per barrel for a brief period. The risk-off sentiment led to selloff in equities and rally in gold, developed market sovereign (government) bonds and US dollar.

The outbreak of the virus beyond the Chinese borders shook the governments and Central banks globally and led to calls for coordinated fiscal and monetary response from major economies.

The 10 year US treasury yield fell from the highs of 1.6% during mid-February to historic lows near 1% by the month end and subsequently dipped below 1% after the US Federal Reserve took a lead by delivering 50 basis points emergency rate cut to tackle the economic impact of the virus.

The RBI governor Shaktikanta Das also favored the idea of coordinated response to the global epidemic and hinted of enough scope to reduce policy rates despite elevated headline CPI numbers. Indian bonds gained on these developments with the 10 year government bond yield falling to ~6.25%.

Softer global backdrop and hopes of larger than 25 bps rate cut by the RBI will continue to support investors’ sentiment in the bond market. If the virus situation persists for longer and spreads further, the bond market will price for deeper rate cuts by the RBI and in that case bond yields can fall below 6%.

Thus with the current set of information it would be reasonable to have some duration (long maturity bonds which gain more with fall in yield) in the bond portfolio. However, we should also be cautious of the fact that global risk off sentiment typically lead to selloff in emerging market currencies and bonds.

Indian Rupee is on a strong footing backed by lower crude oil prices, low Current Account Deficit (~1% of GDP) and large Foreign exchange reserves (USD 476 billion). Despite that we cannot be confident that the India will be immune to larger EM selloff.

We continue to hold a neutral view (with some tactical long duration positions) on the bond markets and view the current rally in the bond market as a temporary reaction to global uncertainty which can reverse very sharply. We still do not see any structural investment play in bond funds. Thus investors in bond funds should 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 have been of the opinion that the credit crisis which began in the bond markets post IL&FS default is not over yet. The recent developments of financial stress in the Vodafone Idea and imposition of moratorium on Yes Bank by the RBI have once again raised the vulnerability in the credit market.

Given the excess liquidity situation, which we expect to continue, returns from overnight and liquid funds will remain muted.

As always, investors in debt funds should prioritize safety and liquidity over returns and should invest in bond funds only with a long term time horizon and keeping in mind that in the short term returns from bond funds may be volatile and may also be negative.

Data Source: Bloomberg, RBI

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