The emerging market contagion gained currency in the last few months as the market turbulence in Turkey and Argentina spilled over to other emerging nations. India was no exception; the rupee has fallen over 11% since start of 2018 to close the month near all-time low of Rs 71/USD. The emerging market contagion was not the only reason for this sell-off in the rupee. The usual suspect, crude oil, also played its part. In the past month, brent oil price jumped from the low of $70/barrel to around $78 on continued concerns on Iran oil supply as the US government sanctions kick in by November.
Bond yield rises
The sharp move in currency and crude oil hit investor sentiments in the bond markets as well. Bond yields across the curve moved higher in August. The 10-year benchmark government bond yield surged by 18 basis points to end the month at 7.95% and similar move was witnessed in other maturity profiles as well. Compared to government bonds, impact on corporate bonds was a lot lower which moved up by 5-10 bps only, but we have seen over years the corporate bond yields respond to market volatility with a lag and we would expect to see similar yields increase in corporate bonds also.
Emerging market volatility and crude oil concerns are likely to be the main driver for the rupee and bond markets in the near term. However, in our view, any sell-off would be a good buying opportunity for long- term bond investors to accumulate Indian government bonds. Our constructive view on the bond markets is based on following assessments:
At current valuations bonds are already pricing for most of the material risks. The 10-year government bond is currently trading at 150 bps over the repo rate against the long-term median spread of around 70 bps. Even if the RBI hikes the repo rate by another 50 bps (0.5%), the bond yields will still be trading above their long-term fair valuation levels.
An added concerning factor which will influence the bond yields going forward is the demand-supply dynamics. The central government had borrowed a lower proportion (48% vs 60%-65% usual trend) of total requirement during Apr-Sep’18. So the issuance of central government securities may rise substantially in the second half. We would also see higher borrowing by state governments.
RBI rate hike
We expect the RBI will need to increase the pace of open market operation (buy government securities to infuse liquidity) from September which will balance the demand side over time to a large extent. To keep the durable liquidity near neutral as with their stated liquidity stance, we expect the RBI may have to conduct OMOs of over Rs 1 lakh crore in the rest of FY19. The OMOs in such large size if they materialise should support the bond yields from rising.
If the outlook does not improve and sentiment towards emerging markets continues to remain weak, the rupee may weaken further and impact the sentiment in the bond market, also putting upward pressure on especially the long-term bond yields (10 year and above) despite the prospect of OMOs. The 10-year government bond yield may hover around 8.0% for now and move towards 8.25% if the market expects RBI to hike by more than 50 bps. As for now, we still do not expect 10-year government bond yields to go up considerably above 8.25% unless macro situation changes materially.
We have always advised investors to have a longer time-frame if they invest in bond funds. They should note that bond fund returns are not like fixed deposit returns and can remain highly volatile or even negative in a shorter time-frame.
The writer is fund manager, Fixed Income, Quantum Mutual Fund