Though G-Secs yields have moved up from 6.4% in July to 7% now, in the absence of any strong driver to move interest rates down, there isn’t any strong case for taking exposure to duration products. Rather, short bond products look better on a risk-reward basis.
In the G-Secs market, there has been an upward movement of yields (i.e., decline in prices) over the last four months. The benchmark 10-year G-Sec yield has moved up from 6.4% in July to more than 7% now. To that extent, it is a better entry level into Long Bond Funds at this juncture than in July. For a perspective, the upward adjustment in yields has discounted a lot of events. These events are:
• Apprehension of fiscal slippage: the fiscal deficit target of 3.2% for FY 2017-18 may not be achieved; the apprehension of a slippage to say 3.5% of GDP is keeping the market wary
• Inflation (CPI) has ticked up from 1.5% in August to 3.6% in October
• RBI outlook on inflation for the second half of the financial year has changed from 3.5- 4.5% to 4.2- 4.6%, as communicated in the Policy Review on October 4
• Subtle change in RBI’s tone on rate action guidance, in the last Policy Review
• US Treasury yield uptick and gradual withdrawal of liquidity from their system
• Bank Recap Bonds and positive impact on credit growth and consequent positive impact on GDP growth
• Expectation of GDP growth revival, from 5.7% in April-June ’17 to average 6.7% for the entire year, which means growth in the other three quarters will be that much better
• Deterioration in CAD in Q1 of FY18, to 2.4% of GDP
• RBI OMOs and reduction in system liquidity surplus—it means higher supply of bonds to the banking system, which is the major buyers of bonds
• Crude oil price up-tick, with consequent impact on our inflation and trade deficit.
One argument at this juncture, after yields having moved up, is that if you were wondering in July whether to enter duration funds, you have a better entry point now. The positive aspects, in favour of yields coming down (i.e. bond prices moving up) are: Real positive interest rates are at a historical high. Taking the representative yield rate as the 1-year Treasury Bill yield level, which is approximately 6.27% and the latest CPI inflation data at 3.58%, the real interest rate is 2.69%. Even if we take inflation at the mid-point of RBI’s projection of 4.2- 4.6%, i.e., at 4.4%, interest rate is positive at 1.87%. This provides enough room to the RBI to take a benign view on the interest rate structure.
On events, the India rating upgrade by Moody’s is a positive on INR levels and FII investments. FII investments in debt is subject to limits, but equity investments are buoyant. Crude oil prices have stabilised, and US shale oil supplies would kick in, after a time lag, if oil prices remain consistently high.
On a risk-reward basis, even at a better entry level than earlier, it does not look like a favourable case at this juncture. Why? Let’s distinguish between ‘what should happen’ and ‘what is likely to happen’. While real interest rates are positive, and highly positive as per historical standards, the RBI’s stance on rate is neutral. This means, unless there is a compelling case for reduction of interest rates, they would hold status quo. Inflation may inch up in the second half of the current financial year, the US is likely to hike interest rates, and there are apprehensions of a fiscal slippage in the current year. In the absence of any strong driver to move interest rates down, there isn’t any strong case for taking exposure to duration products.
The other risk is the ‘spread’ between G-Secs and corporate bonds. Corporate bonds trade at a spread, i.e., higher yield over G-Secs. While G-Sec yields have moved up over the last four months or so, corporate bond yields have not moved up as much, and there is a possibility bond yields may tick up. Net-net, for fresh exposures, short bond products look better on a risk-reward basis.
The author is managing partner, Sen & Apte Consulting Services LLP