Bond not the Best
Rising yields mean bond fund portfolios will be under pressure for a considerable time period.
Rising bond yields and the resulting treasury losses are telling on profitability of banks. Yield on the benchmark 10-year government securities (G-sec) surged 67 basis points (bps) during the third quarter due to fiscal worries. To be sure, these are mark-to-market, or MTM, losses on investment portfolios that can be reversed if the yields correct. But experts think there is a larger concern. "Banks are not actively participating in the market. This is driving up yields," says Dwijendra Srivastava, who oversees around Rs 18,000 crore in various debt schemes as Chief Investment Officer, Debt, Sundaram Asset Management Company.
Once Bitten, Twice Shy
The one-side movement of bond yields since September last year is troubling bankers. Banks are apprehensive of committing more investments as they fear more losses if yields further harden from here.
According to ratings agency ICRA, the yield on the old 10-year government of India security (6.79 per cent GS 2027) had increased by 123 basis points (bps) to 7.72 per cent on February 14, 2018, from 6.48 per cent on September 1, 2017. Moreover, the yield on the new 10-year benchmark G-Sec (7.17 per cent GS 2028) rose from 7.17 per cent, when it was first issued in January 2018, to 7.60 per cent on February 1, 2018, before easing somewhat to 7.49 per cent as on February 14, 2018. "There is clearly a demand-supply mismatch," says Srivastava. "If government front loads its expenditure, it will also front-load its borrowing. We should not forget that it's a pre-election year. Banks need to come back (to the market). At the policy level, a lot of engagement will be needed," he says.
The RBI ensures demand for government paper by mandating banks to maintain a statutory liquidity ratio, or SLR, of 19.5 per cent of deposits. However, in the absence of substantial credit off-take, banks SLR is 10 per cent more than what they need to maintain. "Commercial banks already hold a significant portion of their assets in the form of central government bonds, and as credit growth picks up and liquidity surplus narrows, the appetite of commercial banks for more government bonds is likely to decline," Goldman Sachs said in a research note dated February 13.
Budget - Broken Promises
So, will credit growth pick up so that banks can increase lending and not park money in government paper? Although private investment is muted, the government is slated to grow its expenditure by 10 per cent in 2018/19. But for this it will have to breach its fiscal promises.
As feared by the bond markets, not only did the government revise the fiscal deficit target from 3.2 per cent to 3.5 per cent of the gross domestic product (GDP) for FY18, it set the 2018/19 target at 3.3 per cent of GDP as against a promised glide path of 3 per cent of GDP. Due to this, the government will have to borrow `6.06 lakh crore as against `5.8 lakh crore in the current year. For 2018/19, net of redemptions, the figure stands at `4.6 lakh crore. For absorption of more paper, the government will have to offer higher interest rates. A rise in yields will depress prices of existing bonds.
"There was no clarity on many fronts since August last year," says Mahendra Jajoo, who oversees `2,000 crore in assets as head of fixed income at Mirae Asset Global Investments (India). "Trends in oil prices and food inflation were uncertain. Goods and Services Tax collections were uncertain. There was a greater worry of government breaching its fiscal deficit target. Macros suddenly turned challenging for India."
Jajoo is hinting at rising prices of crude oil. In recent months, some global central banks have started tightening. There are also fears of foreign portfolio investors (FPIs) withdrawing from emerging markets like India for safer havens. There are also concerns regarding the strength of the demand for G-secs from banks and FPIs.
"The signals are that FPI limits will be eased gradually for long-term investors," says Srivastava of Sundaram MF. At present, FPIs are allowed to invest in central government securities to the tune of `2.55 lakh crore; the figure for state government securities is `45,000 crore. FPIs have already utilised around 98 per cent of those limits. "The government typically opens up by 5 per cent every year gradually," says Jajoo of Mirae Asset. The problem with allowing more FPI money is that it can lead to rupee appreciation, affecting exports and hitting the economy. FPIs hate rising inflation, which can mean tighter monetary policies, lowering returns on their bond portfolios.
Inflation and Interest Rates
The RBI's monetary policy presented on February 7 left the policy rate unchanged at 6 per cent. The overall stance remained neutral. The RBI raised its consumer price inflation target for the first half of 2018/19 to 5.1-5.6 per cent. For the second half, it projected a 4.5-4.6 per cent range with risks tilted to the upside. "The RBI's view that 'the nascent recovery needs to be carefully nurtured' was a game changer. Equally important was that the stance (neutral) will continue. We are looking at a prolonged pause (in interest rates)," explained Jajoo as yields corrected across maturities after the RBI policy.
The RBI had last cut rates by 25 bps in August 2017. Although hardened bond yields are suggesting a rise in interest rates, most experts think the rates are unlikely to change in the near term. "We do not expect the monetary policy committee to rush into increasing rates at its upcoming meetings. The path of monetary policy will likely remain largely data dependent in the coming months, with a bias for caution," Barclays said in a note dated February 16.
Going into the next fiscal, the inflation outlook will depend on monsoon, oil prices and impact of the minimum support price (MSP) bonanza announced in the Union Budget. "Crude oil is known for its two-way movement. With borrowing over for the current fiscal, bond yields will settle. Things will get clearer by April-May," says Srivastava of Sundaram AMC.
The government's borrowing programme for 2018/19 is expected by March-end or early April. Early estimates of monsoons will also be out by then. The extent of MSP increases for kharif crops will be out by May 2018.
According to ICRA, the new 10-year benchmark G-Sec maturing 2028 will trade in a range of 7.35-7.65 per cent over the next eight months, until September 2018. It remains to be seen what the RBI does to policy rates in its June monetary policy.
For Savers and Investors
Clearly, the RBI is unlikely to change the repo rate - at which banks borrow from it - in a hurry. At the same time, policy makers will try to talk down yields in the near to medium term to lower the borrowing cost of the government.
But as things stand today, G-Sec yields - a gauge of interest rates in the economy - are indicating at least a few 25 bps rate hikes by the RBI. It will be a good opportunity for new fixed income investors to lock in money at higher rates.
Debt funds: Existing investors, especially in debt mutual funds with focus on gilt and income funds, have earned lower returns than bank fixed deposit rates in the last few months. Panic has set in as most investors link volatility with stock markets and see bond markets as risk-free!
"These are notional losses. In a rising interest rate cycle, NAVs will be negatively impacted, and in a falling interest rate cycle, NAVs will be positively impacted and capital gains will accrue. There has been a pause in the interest rate reduction cycle and there is a chance that the rates may rise. However, that seems to be at least a couple of quarters away," says Suresh Sadagopan, Founder, Ladder7 Financial Advisories, a specialist financial planning and advisory firm which caters to around 500 retail and HNI clients.
Suresh adds, "What will work well now is accrual strategy, staying with shorter duration papers to contain the risk of capital erosion and staying with high quality paper. This will minimise risk to a great extent and can yield better returns than FDs on a post-tax basis." To lock-in higher interest rates, one can also consider fixed-maturity plans or FMPs. FMPs are close-ended funds. They have a duration of three years and help avoid volatility between periods.
Investors who can stomach volatility can go for duration funds. "Duration funds offer an investment opportunity as we do not expect a rate hike in the next few months and believe that the high spread of G-Sec yields over the repo rate is more than pricing the near-term concerns. The 10-year G-Sec yield should trend lower once negative sentiments recede. However, only aggressive investors should consider these funds as volatility may remain high," suggests ICICIdirect.com Research.
Fixed Deposit: As inflation keeps the RBI on the edge, interest rates are unlikely to go lower from here. The returns are guaranteed and interest rates are locked up-front. Fixed deposits of some small finance banks are offering good returns. Risk-averse investors can consider these. However, FDs are taxed as per the income tax slab that one falls under. Taxation is a big negative here.
Small Savings Schemes or SSS: Interest rates were lowered by 0.2 per cent in December. Returns are benchmarked to G-secs and tweaked every quarter. Public Provident Fund (PPF) and National Savings Certificate (NSC) fetch a lower annual rate of 7.6 per cent while Kisan Vikas Patra (KVP) yields 7.3 per cent. The girl child savings scheme, Sukanya Samriddhi Account, offers 8.1 per cent annually. SSS returns post tax are a better proposition than bank FDs. Many experts think that in an election year and in high bond yield environment, SSS rates can be expected to be recalibrated upwards.
Jigar Pathak is a freelance writer based in Mumbai