September 09, 2019
Quantum Fixed Income Team
August was a tumultuous month for the Indian bond markets as fiscal risks took the center stage amid rising calls for fiscal stimulus to revive growth. The GDP growth had slowed down considerably in the past four quarters from growth of 8% in the first quarter of fiscal year 2018-19 to mere 5% in the Q1 of FY 2019-20.
Although there is a case for some fiscal support but we have to remember that the government has practically no space to provide anything within its budgeted resources and any material deviation from fiscal consolidation roadmap might be counter-intuitive.
To ease some pressure the government got a fiscal bonanza from the Reserve Bank of India. The RBI transferred a sum of INR 1.76 trillion to the Government. Of this, INR 1.23 trillion is surplus generated during the fiscal year 2018-19 and INR 526 billion is transfer of excess reserves as per the revised Economic Capital Framework (ECF) recommended by Dr. Bimal Jalan Committee.
It may be recalled that the RBI has already paid an interim dividend of INR 280 billion to the government in February this year which was accounted in the government’s fiscal of 2018-19. Thus in the current financial year 2019-20, the Government will receive the rest INR 1.48 trillion which is significantly higher than the government’s budgeted amount of INR 900 billion from the RBI.
Despite this fact, investors remained skeptical on the government’s fiscal position as tax collection is running short of required monthly rate and growth slowdown will further accentuate the problem. Moreover, talks of fiscal stimulus are also clouding the sentiment though government has shown restraint till now.
On this backdrop, bond yields across the curve moved up in the month. The benchmark 10 year government bond yield surged by 19 basis points to close at 6.56% in August as against 6.37% in July. This was despite the 35 bps rate cut in early August. It witnessed increased volatility during the month due to confusing noises around the domestic fiscal policy and the ongoing trade tensions between the US and the China.
On the currency front, the Indian Rupee depreciated against the US Dollar as the rising in trade tensions between the two largest economies started impacting emerging market currencies. The INR depreciated from below 79/USD to cross 72/USD now.
On the positive side the minutes of the RBI’s MPC meeting held in August implies that the RBI will continue to ease monetary policy to support growth as the inflation is projected to remain well within its threshold of 4%.
We expect the RBI will cut the Repo rate by atleast 40-50 bps in the coming months will also keep the banking system liquidity in surplus mode to facilitate transmission of lower repo rates into the real economic.
We opine that the easy monetary conditions will continue to support the bond market. While on the other hand, pressure on the government’s fiscal position and weakening currency outlook remain major risks.
Bond funds with longer maturity profile may benefit from the potential rate cuts; however investors in bond funds should keep the above mentioned risks in mind while trying to benefit from the falling bond yields.
We would also like to remind investors that an interest rates and in turn bond fund returns might be very volatile in shorter time period. Thus investors should keep atleast 2-3 years’ time horizon while allocating to bond funds.
Dynamic Bond Funds, which allow the fund manager the flexibility to change the portfolio positioning depending on the emerging situation is a better alternative if you wish to allocate to bond funds and can tolerate the near term volatility in NAV.
Investors with low risk appetite should stick to Liquid Funds to avoid any sharp volatility in their portfolio value. However, while choosing such funds also one should be aware of the credit risk and prefer funds which take low credit and liquidity risks.
Investors should also note that the credit crisis which began in the bond markets in September 2018 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.
Data Source: Bloomberg, RBI
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