Whats up with Indian Bond Yields?

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The benchmark 10-year G-Sec yield (https://www.bloomberg.com/quote/GIND10YR:IND) has moved from a low of 6.40% in July 2017 to over 7.9% now. This has multiple levels of impact on the economy as these feed through into impacts on equity, currency markets and then transmitted to the real economy via lending rates, borrowing rates and finally via portfolios.

So whats been causing all this? And what should one do to protect portfolios?

We present below key factors that have all led to this upward pressure on yields:

1) US Treasury yields crossed the 3% mark for the first time since 2013 and the tightening cycle that has led to this has begun globally as early as Q3 last year even as RBI didnt do much. With rates firming up globally, foreign portfolio investors, who are key players in the bond market, have been in sell mode in India withdrawing a massive $6.7 billion between April 1 and June 6, 2018, as per the Monetary Policy Comiitee (MPC). Soaring yields have prompted other bond buyers — insurance firms, mutual funds and pension funds — to shy away from long-dated g-secs which causes oversupply and therefore rise in yields.

2) Oil recently reached the $80 per barrel mark. Rising oil prices creates fears of inflation and fiscal slippage and If oil related excise duties are reduced, due to election  year compulsions,  the deficit might widen which again means oversupply of government bonds. Government spending was the major contributor to the Q4 GDP growth that came in at 7.7 per cent. With GST revenues not yet stabilised and Air India divestment not likely to go through, there are risks of fiscal slippage. This implies potential oversupply of bonds in the future and  markets start discounting that.

3) RBI revised its projection for CPI inflation to a range of 4.8% – 4.9% in H1 (April 2018 projection range of 4.7% to 5.1%) and 4.7% in H2 (April 2018 projection of 4.4%), including the HRA impact for central government employees (excluding the impact of HRA, CPI projection is 4.6% in H1 and 4.7% in H2), with risks tilted to the upside. The revision from April  reflects high core CPI inflation (ex food & fuel) and the recent spike in the price of the Indian crude by 12%. RBI and GOI obsession with inflation (read CPI) is a well known target and therefore, markets have been discounting rising rates with each reading.

4) The USD is strong  as global front trade tensions, developments in Spain and Italy, and Brexit related headlines continue to set the tone for risk sentiment. The US has extended tariffs to its allies Mexico, Canada and EU as well apart from ongoing issues with EU. Note that If crude basket averages $68–72.86 per barrel and rupee averages 66.6-67 per US$, the current account deficit could widen to $22-31 billion in FY19. This has led to the rupee being the worst performing Asian emerging market currency in 2018. While the currency is down 5.86 per cent against the dollar so far this year, only the Philippine peso (5.11 per cent) and Indonesian rupiah (3.37 per cent) have fared as badly as the rupee. Some Asian currencies, such as the Japanese yen, Thai baht and the Malaysian ringgit, have actually gained against the dollar this year.

5) Historically, bank credit numbers show that the first half of the financial year accounts for approximately 20% of credit growth for the year. The remaining 6 months account for the balance 80%. Now we are looking at the risk of government borrowing crowding out corporate credit even as liquidity is getting tighter.

6) Finally the Gsec supply created by the Centre’s borrowings is usually mopped up by banks to fulfil their 19.5% SLR (statutory liquidity ratio) requirement. But post-demonetisation, domestic banks have been flush with funds and took to parking these surpluses in G-secs, resulting in them holding as much as 30% in SLR securities. With credit offtake picking up in recent few months, banks have gone slow with their g-sec purchases, to ensure that they had funds to lend.

The Markets Knew!

There have been symptoms that the RBI would raise rates even prior to the latest policy which is probably why the post policy GSec movement has not been as volatile – yields had already moved up substantially and the RBI just caught up to that.

Consider bond markets first. While the MPC had been in pause mode for the last 10 months, the yield on the 10-year government bond, the benchmark for market interest rates, had already shot up by 120 basis points from 6.60% to 7.83%. For three straight weeks prior to the policy, the RBI couldn’t sell everything on offer, leading to a spike in bond yields, as more than 80% of the issues devolved on  the primary dealers.

Even with the banking system, with deposit flows slowing down and credit offtake picking up, banks have had to hike their retail and bulk deposit rates by 25-50 basis points over the last six months to woo new depositors showing the liquidity issues.

Finally and probably to create some short term liquidity , the Reserve Bank had in May 2018 permitted FPIs to invest in treasury bills issued by the central government.


Our Recommendation

Yields at current levels definitely look enticing – According to us, the best strategy at the moment for the neutral investor is to either look at funds closer to the shorter end of duration , if you are not looking at risk,  or lock into high yields via Fixed Maturity Plans or the Long Tenor GSec funds like Reliance Nivesh Lakshya.

For high risk investors who think rates may be close to peaking out as well as recovery is on its way,  aggressive credit risk funds like Franklin India Credit Risk Fund (erstwhile Franklin India Corporate Bond Opportunities Fund) are ideal as it is positioned as a fund that seeks to maximize portfolio yield by primarily investing in AA and below rated corporate bonds (excluding AA+ rated corporate bonds).

For the brave hearted, participating via the interest rate futures on NSE could be an option to express his or her own views.

Finally, one could also look at Tax Free Bonds listed on the exchanges to lock in good yields – close to 6.25% tax free on average currently.

For those who dont fancy tricky stuff, any surpluses that are lying around under your pillows should be swiftly moved to virtually risk free liquid plans earning upwards of 6.25%– today!

Remember – If debt funds redeemed after three years, an investor has to pay 20% Long Term Capital Gains with indexation benefit. However, if the holding period is less than 3 years, you have to pay tax according to relevant tax rates.

Write to us at mfss@plindia.com to understand more about your investment options and/or advice on your existing portfolios!


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