Debt outlook: Keep a longer timeframe; possibility of losses in short term

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New Delhi | Published: July 17, 2018 2:15:33 AM

Indian bond yields continued its upward march posting an eleventh monthly rise in the last 12 months. A sharp uptick in inflation, higher crude oil prices and weaker rupee against the dollar reinforced the bearish bias in the market.

The 10-year benchmark G-Sec (central government bond) yield breached the psychological 8% mark which was last seen in early 2015.

Indian bond yields continued its upward march posting an eleventh monthly rise in the last 12 months. A sharp uptick in inflation, higher crude oil prices and weaker rupee against the dollar reinforced the bearish bias in the market.

The 10-year benchmark G-Sec (central government bond) yield breached the psychological 8% mark which was last seen in early 2015. But it retreated from there to end at 7.90% in June compared to 7.83% in May this year. The government bond yields across maturities showed a similar movement rising by 5-10 basis points (bps) in June. The yield on corporate bonds also rose by 5-10 bps across the curve. The 10-year AAA rated PSU bond is now near 8.6% and similar three-year bond is at 8.5%.

Weakening domestic macros
Given the weak sentiment on emerging markets and weakening domestic macros, we may see the rupee’s depreciation bias to continue rest of the year. One of the major effects of rupee depreciation is that it raises the cost of imports. Higher import bills could translate into higher inflation and in turn could further affect the bond markets negatively. Fall in the rupee’s value also reduces the return on investments for foreign portfolio investors making their investments in Indian bonds less favourable. In the last four years, foreigners have poured in substantial investments into Indian debt markets. Foreigners have sold about $7 billion (year-to-date) YTD but further weakness in rupee will test their resolve and could potentially trigger some more position unwinding.

Following the sharp fall in crude oil prices in 2015 and 2016, the Organization of the Petroleum Exporting Countries (OPEC) and non-OPEC countries (led by Russia) had entered into a pact in December 2016 to jointly cut output by 1.8 million barrels per day (bpd). But the unexpected fall in production in Venezuela, Libya and Angola have brought the supply cuts to around 147% of the agreed levels in the recent months which drove the prices to near $80 per barrel.

Domestic liquidity
The domestic liquidity situation continued to tighten as cash withdrawals remained at elevated levels. The recent trend of RBI’s purchase and sale of FX reserves suggests that RBI had cancelled some of its long forward positions in foreign currencies in the last month. If the pressure on rupee continues in coming months, we may see more cancellation of forward positions by RBI and can even witness increased selling of dollars in the spot market which will lead to further tightening of liquidity conditions. The government raised the minimum support prices for Kharif crops by at least 1.5 times of the production costs of the respective crops. We believe this will add to inflationary pressures over the next year. In the MPC meeting next month, RBI may revise its inflation projections upward and may also frontload the rate hike to curtail inflationary expectations.

Fixed income outlook
India government bond yields now at around the 8% mark and the shorter end AAA PSU corporate bonds at 8.5% have priced in significant uncertainty risk premium around oil prices, foreign investor behaviour, rupee movement, liquidity actions. The 10-year government bond yield will likely remain in the 7.7% – 8% range for now and move above towards 8.25% if the markets expect RBI to hike by more than 50 bps. We continue to maintain our neutral stance on rates over the medium term. However, we keep looking for signs of mispricing in market and position to exploit the opportunity tactically. We advise investors to have a longer timeframe if they invest in bond funds and also consider the possibility of capital losses in the short term.

Pankaj Pathak  is fund manager, Fixed Income, Quantum Mutual Fund

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