Debt Outlook for 2020

Despite few hiccups and an increased level of volatility, 2019 turned out to be an incredible year for the bond market. The year started with a synchronized monetary easing across the globe to tackle the slowing global economy.

In India, the prevailing NBFC crisis made the growth slowdown even more pronounced. The RBI, under the new Governor, acted swiftly by cutting policy repo rate by cumulative 135 bps (1.35%) in five consecutive MPC meetings. On top of that, it flushed the banking system with liquidity, to further ease financial conditions resulting in a marked ‘flight to safety’.

This helped government bonds and high rated corporate bonds, which gained in market value (bond yields fell) and in turn benefited long duration bond funds (bond funds which invest in longer maturity debt instruments). At the same time, the easy monetary conditions pulled down the short term money market yields to multi-year lows which lowered the returns on Liquid funds and other money market categories.

In response to the aggressive rate cuts, yield on the 10 year benchmark bond declined from 7.4% at start of 2019 to 6.6% now. During the same time the yield on 3 months Treasury bill declined by much higher proportion from 6.75% to near 5.0% now. Borrowing cost for PSUs and good credit quality corporates also came down in the year. The 5 year AAA rated PSU bond which was trading around 8.2% in January 2019 is now close to 7%. While interest rate on 1 year PSU commercial paper has declined from 8.1% to 6.0% now.

Despite having the desired effect of lower interest rates in the money markets, this generous monetary easing (of rate cuts and easy liquidity) failed to revive investors’ confidence in the credit markets, which continued to face multiple shocks in the form of rating downgrades and defaults throughout the year. Credit funds were one of the worst underperformers in 2019.

Going into 2020, we expect this divergence between the high quality bonds and low quality credit segments to persist. There are some pockets of stress still visible in the credit markets especially in the real estate and NBFC sectors which in our view can have serious negative shocks to the (lower rated/quality credit) category. Also in the backdrop of the general economic slowdown, corporate growth and profitability will remain under stress.

On the other hand government bonds and high quality corporate bonds continue to offer decent value, though it seems unlikely even for these to repeat 2019’s stellar performance. In 2020, bond returns will be determined primarily by the changes in growth inflation dynamics in India and globally. While the government’s fiscal outlook and progress towards global bond index inclusion will have binary effect on the rates.

Inflation has recently picked up in India due to sudden shock increase in vegetable prices. The RBI in its latest MPC (Monetary Policy Committee) meeting flagged this risk and kept policy rates on hold despite sharp slowdown in growth. However, the MPC members also acknowledged the increased divergence between the various components of the inflation basket and transitory nature of vegetable price shocks.

Remember the Core inflation (ex-food and fuel prices) which is better reflection of economic activity is still near 3.5% well below the recent headline inflation reading of 5.5% and the neutral inflation target of 4%. Even the ex-vegetable CPI which represents almost 94% of the CPI basket was at 3.5% in November 2019 which shows that underlying inflation is still at comfortable levels.

We expect the broader inflationary pressure to increase in 2020 mainly driven by a few essential food items. However, the average headline CPI would remain near the 4% neutral inflation target of the RBI and may not warrant any hawkish approach in policy settings. On the contrary if the growth situation does not improve there could be further monetary easing in 2020.

The RBI, in its recent monetary review, explicitly guided on the available monetary space and possibility of more rate cuts in near future. Based on our current assessment, we expect 25-50 basis points cut in repo rate in 2020. We also expect the current surplus liquidity framework to continue in the next year till we see notable signs of growth recovery.

On the global front major central banks appear intent on maintaining easy policies – and interest rates and bond yields look likely to linger near the current levels. Nevertheless the recent optimism over resolution of trade dispute, softer Brexit deal and potential fiscal stimulus by major developed economies could create an environment for reflation and push the central banks into fighting mode. We believe the dovish pivot by global central banks is largely behind us for now, but do not see any major bounce upward in bond yields in 2020 amid sluggish global growth. The main risk to this call could come from much bigger fiscal stimulus and widening of fiscal gap by major economies.

In India also there is a huge cry out for fiscal stimulus to revive the slackening economic growth. Remember the government has already given a bonanza to the industry by cutting the corporate tax rate from 30% to 25% in general and to 17% for new manufacturing units. This is estimated to free up Rs. 1.45 trillion for the industry and thus would cause a similar shortfall for the government’s tax collections.

There is an expectation that the central government will breach its FY 2019-20 fiscal deficit target of 3.3% of GDP by 30-50 basis points and will likely increase the market borrowings by Rs. 300-500 billion from the bond market during February-March 2020. This has been a major worry for the bond investors in the last few months and is fairly reflected in the steepness of the sovereign yield curve with the 10 year government bond trading at ~150 basis points above the policy repo rate.

There are also some media reports speculating about reduction in personal tax rate and other form of fiscal stimulus to be announced in the next year’s budget which will be presented on the February 1, 2020. Even if the government restrain itself from giving any more fiscal package, it would be extremely difficult for them to maintain the earlier laid down fiscal consolidation roadmap of reaching 3% Fiscal Deficit to GDP by FY 21 as pace of tax collections might remain muted in the next fiscal as well.

The extent of gross supply of bonds from the center and state governments and PSUs will remain a risk to the overall demand supply dynamics in the bond market. However on the positive side there is a reasonable possibility that the government will raise part of its market borrowing through offshore bond issuance next year. The government announced it in the last budget but put it on back burner for this fiscal. If the govt is able to overcome the opposition and issue sovereign bonds in the global markets, it can lower the burden of increased supply from the domestic investors and will be a positive move for the bond markets in general.

There are also talks of including the Indian bonds into the Global Bond Indices. The government has shown a clear intent to achieve this sooner than later. Inclusion in global bond index can boost India’s potential to attract long term debt capital into the economy which is very much needed to fund the planned spending on country’s infrastructure. This has a potential to become a landmark reform for the Indian debt markets.

With this macro backdrop we have a neutral stance on the bond markets in 2020. However from the valuation point of view the longer maturity segment of the government bond curve is attractively priced and is already discounting much of the fiscal risks. We are therefore biased towards a tactical high duration positioning in our dynamic bond fund. But we are also mindful that the macro situation will remain very fluid in the next year and thus we would stay nimble to adjust our duration position actively should things change from our expected line.

The term spread between the 10 year government bond yields over the repo rate has been hovering around 150 basis points in the last few months compared to its long term average of roughly 80 basis points. This is at a time when economy is growing at a pace well below its potential, CPI inflation (average) is close to its optimal levels and monetary policy is in accommodative mode. Part of this high term spread is on account of elevated fiscal risks and would likely compress when the fiscal uncertainty goes away.

The negative side of the high term premiums is that it tends to hamper the monetary transmission into the real economy especially in the rate easing cycle. To address this concern the RBI recently decided to intervene in the bond market with an unconventional tool. The RBI conducted a special Open Market Operation (OMO) commonly referred as “Operation Twist” under which it bought longer maturity bond (10 year government bond) and simultaneously sold shorter maturity bonds (up to 1 year maturity). This move clearly signaled the RBI’s discomfort with the high level of term spreads and led to sharp decline in yields in the longer segment. We believe the RBI will conduct more such operation twists in coming months to bring down the spreads further.

We also like to once again caution investors that that the best of the bond market rally is behind us now and Investors in bond funds should keep the market risks in mind while trying to benefit from any further fall bond yields. They should also lower down their return expectations from bond funds and from money market funds in the coming year.

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.

Investors should also note that the credit crisis which began in the bond markets post IL&FS default is not over yet and investors should remain cautious and should always choose debt and liquid funds which priorities safety and liquidity over returns in the current times.

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