Trajectory of fiscal deficit key variable for fixed income market

Written by Joydeep Sen | Updated: Jul 8 2014, 08:24am hrs
The Budget is a key variable for equity investments due to its impact on various segments of the economy. For the fixed-income market, in particular, fiscal deficit is very important factor.

The smaller the deficit, the better it is for fixed-income investments. It was pegged at 4.1% of GDP in the interim Budget. So, what does the new government do now As per the noises so far, it is in favour of taking less-populist but necessary measures in the overall interest of the economy.

A big problem at hand is how to handle more than R1 lakh crore of pending subsidy related to the previous financial year. The government may take stop-gap measures and communicate strongly that these are one-time steps. One such measure is to allow OMCs to issue oil bonds, thereby shifting the burden for the time-being. Disinvestment of PSUs can be done in subsequent years as well. At the end of the financial year, the government may roll over a part of the burden to next year. But only once; the practice has to stop somewhere.

An important aspect of the Budget would be the roadmap on target deficit for the next four years and how serious the government is on curtailing food, fertiliser and oil subsidies. The message should be strong and clear the government means business and is working on real containment, without curtailing capacity creation.

The government borrowing from the market is close to R6 lakh crore on a gross basis, i.e., without counting redemptions of G-Secs during the year. If the deficit target is set higher and the government borrowing moves upward to an acceptable limit (say by R25,000-30,000 crore) and there is a roadmap on containment of deficit, the market would not react much. Any digression beyond acceptable limits would lead to negativity in market sentiments.

The reaction of fixed-income investors to the Budget and fiscal deficit is that if the deficit is lower than expectations, it is positive for future yield movements and it is worth taking exposure to bond funds. On the other hand, if the deficit is on the higher side, it is safer to be in defensive funds.

However, this is a thumb rule only and exposure to long-bond funds should be taken only when there is conviction on the view that rates are expected to come down.

In a nutshell, the Budget an important event for fixed-income investments, but it is not the only input for the decision on long-bond fund investments. Till we get conviction on the view, it is advisable to stick to relatively defensive fund categories like short-term bond funds and closed-ended funds. Closed-ended funds of 2-3 year maturity are preferable as it does away with the reinvestment rate issue as interest rates are expected to ease after a year or so.

n The author is a financial analyst.

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