Debt fund investors are advised to choose safety (over credit) and liquidity (over spreads and returns) while investing in bond funds.
by Pankaj Pathak
After the sharp fall seen in the last quarter of 2018, bond yields rose steadily at start of the year. This was mainly due to reversal in the global crude oil prices which rebounded more than 20% from its recent bottom. Apart from crude oil, government’s fiscal slippage and RBI’s Open Market Operations also generated push-pull effect on the yield curve and resulted in divergent movement in yields on different maturity profiles.
Yield rises for long tenure bonds
The yield on most traded 10-year bond (7.17% GS 2028) rose from the bottom of 7.22% in late December and is now trading near 7.5%. Similarly, all other long tenure bonds witnessed a moderate rise in the yields. However, yields on the shorter maturity bonds (1-5 year maturity) declined by 10-20 basis points since the start of the year. The new 10-year bond, which was priced at 7.26% in auction on January 14, moved up closer to 7.4% and is now trading near 7.3%.
The spread of yields on state governments bonds and PSU bonds over respective government securities have also widened in the last one month. We believe this divergence was primarily on account of the RBI’s Open Market Operations (OMO). The RBI increased its pace of OMO operations in December and January to purchase government bonds worth `500 billion per month.
RBI cuts rate
In its last bi-monthly policy of this fiscal, the Monetary Policy Committee (MPC) of RBI cut the policy repo rate by 25 bps to 6.25% and changed the policy stance from ‘Calibrated Tightening’ to ‘Neutral’. Although the rate cut was not widely expected, it was in line with the benign inflation trend and softer global outlook. The RBI revised down its inflation projections yet again pegging the CPI inflation below 4% for the entire 2019. In the Interim Budget, the government once again deviated from its fiscal consolidation roadmap expanding the FY19 fiscal deficit to 3.4% of GDP from the initial budget estimate of 3.3%. The fiscal deficit target for FY20 is also raised to 3.4% of GDP as against 3.1% as per the FRBM glide path. The fiscal slippage was mainly due to newly introduced Farm Income Support Scheme with a proposed expenditure of up to Rs 200 billion in FY19 and Rs 750 billion (0.3% of GDP) in FY20.
In order to fund the fiscal slippage the central government has announced to borrow an additional Rs 360 billion through dated securities and Rs 80 billion through treasury bills in March. In the financial year 2019-20 the central government’s gross market borrowing is pegged at Rs 7.1 trillion (vs Rs 5.71 trillion in FY19) while the net borrowing will be Rs 73 trillion. The bond supply is not only of the Centre but gets overwhelmingly large when we combine market borrowing by state governments and quasi government bodies (PSUs). The markets will have to absorb almost Rs 5.3 trillion in bond issuances by state governments, most of whom have also casually abandoned their fiscal rectitude.
Election year impact
We are entering into an uncertain election cycle; we believe foreign investor demand will also remain muted until there is clarity on the next government and its likely macro-economic policies. So despite, a general wave of bullishness towards emerging markets on FED dovishness, India is unlikely to be a key beneficiary till at least May 2019. We always advise investors to have a longer time frame if they invest in bond funds and should also note that the bond fund returns are not like fixed deposits and can be highly volatile or even negative in a shorter time frame. We also advise debt fund investors to continue to choose safety (over credit) and liquidity (over spreads and returns) while investing in bond funds.
(The writer is fund manager, Fixed Income, Quantum Mutual Fund)