Indian bonds: Looking attractive again...

Updated: Aug 11 2014, 14:53pm hrs
After the landslide victory of the BJP-led NDA in the general elections in May 2014, the equity markets have witnessed a very strong performance and are seeing significant FII flows.

Even as investors are super excited about equity markets, we would like to argue that bonds are looking equally attractive. Here is why we think so.

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Why are Indian bonds looking attractive

(i) Absolute yield

Indian 10-year yields (the conventional benchmark) continue to trade at close to their highest levels over the last decade. The chart shows the movement of the 10-year bonds in the last 10 years.

(ii) Relative value versus international bonds

Indian bonds offer a significant relative value opportunity at a time when central banks around the world are following unprecedented easy monetary policies. At the recently concluded meeting, the European Central Bank (ECB) made some landmark moves lowering deposit rates to a negative zone (minus 0.10 %). Other countries such as Japan are continuing with their measures to revive growth through Quantitative Easing (QE) and QE variants. Even as US winds down its QE programme, probability of a near-term rate hike appears weak.

The differential between INR and USD benchmark yields stands at close to 6.0% as on date. The UST is currently trading below its long-term average, while the Indian sovereign bonds are trading well above the long-term average.

(iii) Significant improvement in macro environment

Post August 2013, the domestic macro environment has undergone good improvement on most of the key parameters.

(a) Improving current account, stable INR

Following the curbs on gold imports and a fall in gold prices, there has been a significant improvement in the current account scenario. The CAD in FY 14 was the lowest in the last five years and March 2014 CAD was the lowest in the last 20 quarters.

After remaining flat for a long period, the reserves have started growing. Post July 2013, FCNR deposits and FII flows have augmented reserves. As mentioned earlier, net flows into equity and debt aggregate over $17 billion y-t-d. In a bid to prevent the INR appreciating strongly, RBI has been mopping up most of the flows, which is reflected in an improving reserves position.

(b) Stable government and policy regime

Given the stability that the new government will have at the Centre, it can be expected to take some bold reforms to stimulate growth and overcome some of the policy inertia witnessed in the last few years. These measures are expected to yield growth benefits in the coming years and pull up growth from the sub-5% levels at present to 6-6.5%.

Efforts of macro stabilisation undertaken in the last few quarters seem to be yielding some positive results as well. The pick-up in economic activity in the last two months has been promising. Key indicators such as exports are up and IIP is at a more than two-year high. Simultaneously, inflation has started coming off. Forex reserves are also near life-time highs after having remained flat for almost five years. Even as rates remain elevated, a stable foundation and a robust macro environment could support an incipient recovery in the coming quarters.

(c) Responsible fiscal conduct to complement RBI efforts

The government has embarked on an aggressive fiscal consolidation programme, planning to cut the deficit from 4.5% in FY14 to 3.0% in FY17. While the deficit target assumes optimistic revenue growth targets, a rebound in economic growth in the second half of the financial year could help in bridging the gap. Gross tax collections are projected to grow at 19.7% as against 21% in the Interim Budget. Direct subsidies are forecast at 2% of GDP (in line with the Interim Budget), lower than in the previous year (2.3%).

Successful reduction of deficit could further strengthen the macro position. Pre-emption of bank deposits to government bonds could further reduce, leaving banks [with] liquidity to finance more productive segments of the economy. Funding costs for the private sector could reduce as fund availability within the system increases.

(d) Inflation expected to start moderating

Historically, WPI was employed as a measure to track inflation. The recent move to employing CPI was partly the reason for the three rate hikes witnessed in the second half of CY2013.

While inflation has been impacted by supply-side factors, the benefits are materialising with the usual lagged effect. The June CPI reading below 8%, while partly supported by the base effect, has also been helped by a sequential deceleration in input prices.

Inflation is also likely to progressively decline as government spending tilts from being expansionary to neutral. While part of this process has been completed, lowering of fiscal deficit would further help moderate inflation in the coming quarters.

Execution of incomplete and pending projects is expected to take more time as reforms are being undertaken.

RBI getting comfortable, but not yet....

At the recent bi-monthly monetary policy meeting, RBI reiterated its commitment to build inflation credibility for the Indian central bank. While RBI appears comfortable with the progress achieved in the last few months, the central bank considers it premature to declare that the war on inflation has been won even as CPI has declined to sub-8%.

RBI has hence, in our view, for the first time referred to the need to still meet the January 2016 target of 6% on CPI. Given the relatively longer tenor to reach this milestone, RBI has also referred to possible upside risks to the FY16 target (of 6%) given global uncertainties and event risks.

In our view, RBI moved to a neutral stance at the June meeting. Through its reference to the 2016 CPI target, we believe that RBI is merely sensitising the market to probable upside risks. This is likely to help in capping forward inflation expectations. However, it will also conversely mean holding the current repo rate for a higher-than-consensus period.

Yields could start trending lower despite steady rates....

Even as policy rate cuts could be a while away, other supporting factors necessary for yield softening and imparting a growth stimulus, seem to be falling in place gradually. Monsoon, which was poor in June, improved in July and early August. As a result, the national rainfall deficit which was in excess of 40% at the end of June has almost halved to a 21% by July end. If monsoon picks up in August, the final deficit could fall significantly. For comparsion purposes, rainfall deficit in 2009 was 27%, which was a drought year. Besides, India is at present sitting on adequate buffer food-grain stocks and these should be able to mitigate part of the negative impact on food production if it were to materialise.

The minimum support price (MSP) revisions in June were also at a weighted average of 2%, the lowest in five years. We believe that these are very strong signals which would influence bond yields going forward.

The government has emphasised to maintain continuity in fiscal consolidation by moving to a 3% deficit target in the next three years. Despite some headwinds in the current fiscal, the government decided not to take the liberty to deviate from the 4.1% target spelt out in the Interim Budget.

Given this background, we believe that medium and long-end rates will gradually start building in softening bias expectations which should help yields trend lower. We believe that more than the 6% Consumer Price Index (CPI) milestone for January 2016, RBI is likely to focus on the disinflationary path, going forward, and may still be in a position to usher in monetary easing if it starts getting comfortable with the trajectory of inflation.

Given this outlook, we advise investors to start allocating money to medium- and long-term bond and gilt funds with a 12-18 month view. Investors with shorter time horizons should consider liquid, ultra short term and short maturity funds as they offer attractive returns for short-term deployment.

According to the new tax rules on debt funds, the investor has to hold the funds for at least 36 months to qualify for long-term capital gains tax. If debt mutual units are held for less than 36 months, it would be taxed according to the investor's tax slab. For investors with an investment horizon of more than three years, debt funds with an accrual strategy would be ideal. For investors who can stay invested for more than three years, fixed maturity plans (FMPs) with a maturity period of more than three years would be ideal considering the elevated level of current yields, benefit of indexation and lower tax rates due to long-term capital gains tax. Existing investors in FMPs can also consider extending their investments for a period of more than three years.

Kumaresh Ramakrishnan

The author is headFixed Income, Deutsche Asset Management