Update & Perspectives
The four major factors that are of consequence for the fixed income or bond market are the policy of the central bank or the official interest rate policy, the liquidity conditions in the interbank market, the government borrowing program and the inflation trajectory. Each factor is detailed in the following paragraphs, along with the perspectives, and specific recommendations in respect of funds or instruments will be shared in the form of product notes.
1. The RBI Policy – Soft and Accommodative
The RBI strongly reaffirmed its commitment to an accommodative policy in the last policy announcement. Apart from a cut in the repo rate, RBI reduced the CRR and also announced further amounts in the long-term repos targeted to enhance the liquidity conditions in the inter-bank market. The RBI action covered every aspect possible for a central bank in terms of its intervention, which included actions from a monetary policy perspective, like the rate action to bring down policy rates directly, liquidity action to support the effective transmission of lower rates to ultimate users of credit, and a number of regulatory and developmental measures. RBI stated that “the macroeconomic risks, both on the demand and supply sides, brought on by the pandemic could be severe. The need of the hour is to do whatever is necessary to shield the domestic economy from the pandemic. Central banks across the world have responded with monetary and regulatory measures – both conventional and unconventional. Governments across the world have unleashed massive fiscal measures, including targeted health services support, to protect economic activity from the impact of the virus. The MPC further noted that the Reserve Bank has taken several measures to inject substantial liquidity in the system. Nonetheless, the priority is to undertake strong and purposeful action in order to minimise the adverse macroeconomic impact of the pandemic.” The RBI particularly noted that the outlook on growth and inflation is highly uncertain. Under these conditions we expect the RBI to pursue a soft money policy in an aggressive fashion. This will have a softening impact on interest rates, and it will be more marked at the short end of the curve.
2. Interbank Liquidity – Consistently in Surplus
Interbank liquidity is one of the key factors determining the rates in the domestic money market. The interbank liquidity conditions have been marked by a surplus for close to six months now, and the average surplus has been to the tune of Rs.2 Lakh Crs. The long- term repos, the preference for staying in cash and cash equivalents, the slow down in the growth of credit etc. have all contributed to the higher liquidity available in the market. An amount close to the overall surplus is being parked by the banks with the RBI on a regular basis. The overnight rate has moved down towards the 4% to 4.50% levels. This supports stable and smooth rates at the short end of the curve.
3. The Government Borrowing Program – Skewed towards longer maturities
The government borrowing program for the first half of 2020-21 was announced recently. It is interesting to look at three features of the borrowing program from an investment perspective, that is the (i) spread of the borrowing program over H1 and H2, (ii) the maturity-wise concentration of the primary issues, and (iii) the month-wise distribution of the same.
The gross market borrowing programme announced in the budget of the central government was to the tune of Rs.7.80L Crs for 20-21, as against Rs.7.10L Crs in 2019-20. The net borrowings, net of debt servicing is at Rs.5.36 L Crs for 20-21 as against Rs.4.99 L Crs in 19-20. Of the gross borrowing program for the whole year 62.50% is the share of the primary issues for H1.
A major portion of the government borrowing program is at the long end of the curve, in longer dated papers. 65% of
the total borrowings is in 10 Years plus maturities. The pressure of the primary issues will be more at the long end of
The program of government borrowings for the first half, and more so for the Q1, is quite large, and would require the liquidity levels in the system to be much higher from the current mark. The pressure, if at all, will be at the long end. The smooth sailing may be facilitated by one or two rate cuts and liquidity addition. Given the current environment of sharp economic slowdown impacting the revenue and the pressures to perk-up the spending may lead to enhanced borrowing in the second half. In the wake of the corona virus impact on the growth numbers, the revenue targets of the government have started to look fairly aggressive. The disinvestment target of Rs. 2.1 trillion for FY21 may get difficult to achieve if the current capital market conditions prevail for an extended period of time. The fears of expansion in fiscal deficit have started reflecting at the longer end of the yield curve. The 10-year benchmark government security is trading close to 6.50 % yield.
4. Fully Accessible Route (FAR) – May promote overseas interest in the long run
In the Union Budget for 20-21, several measures were proposed to enhance the breadth and depth of the markets
which included greater access for overseas investors, introduction of ETFs, and access to infrastructure investments
with a tax holiday. The RBI recently announced enhanced limits for foreign investments in government securities and corporate bonds, and also investment without any cap in the benchmark government securities specified from time to time. The limit for FPI investment in corporate bonds is increased to 15% of outstanding stock for FY 2020-21. This means a revision of limits from Rs.3.17 Lakh Crs to Rs.4.29 Lakh Crs in H1 20-21, and 5.41 Lakh Crs in H2, 20-21. The limits for FPI investment in Central Government securities (G-secs) and State Development Loans (SDLs) for FY 2020-21 have also been revised upwards. But the more significant change is the FAR or the Free Automatic Route which opens up investments without limits by overseas investors in specified securities, notified from time to time. This may also help enhance overseas interest in domestic bond markets over the long term.
5. The Inflation Trajectory
The CPI based inflation numbers eased for the second consecutive month; after touching a high of 7.59% in the month of Jan’20, the headline inflation number for the month of Mar’20 came in at 5.91%. The core inflation numbers too maintained an easing trend. The latest inflation numbers are an estimation, as data collection efforts were suspended with effect from 19th Mar’20; till this date price quotations of 66% of the items had been collated. The seasonality headwinds for food articles have been ebbing since the last three months and that led to softening of Consumer Food Price Index based inflation. The CFP inflation for the month of Mar’20 was reported at 8.76% as compared to 10.81% in the preceding month. The CFP inflation touched the current series high of 14.19% in the month of Dec’19. Vegetables, Pulses and Spices continue to be the major contributors to food inflation, but the pace of growth has eased considerably as compared to previous months. The Core inflation maintained its gradual downward trajectory and was reported at 4.43% in Mar’20 as compared to 4.51% in the preceding month. The country wide lockdown and the resultant demand destruction is expected to keep the core inflation at bay. The CPI based inflation number was reported within the RBI’s target range for the first time in 4 months. This should provide some relief to the central bank in terms of providing it some space to maintain the focus on supporting growth and facilitating swift transmission. The economic impact of COVID 19 is being felt globally; the fiscal and monetary authorities are working in close coordination to minimise the
damage to their respective economies.
From a near term perspective, the inflationary pressures are expected to remain in control as lockdown situation will
keep demand side pressures at bay. Apart from essentials, the demand for all the other goods and services may remain virtually non-existent, and thus, may not see any price escalations. Currently, the food basket remains the only component that can potentially see some upside. From a medium-term perspective, the inflation trajectory would be dependent on supply side management. As the situation normalises over time and regions come out of lockdown, the supply side machinery needs to be maintained in well-oiled condition to meet any surprises from pent-up demand.
6. The Market – Recent Events
The markets after the introduction of the lockdown has become relatively more thin in terms of the volumes and
trades. This may be due to the fact that significant number of people operate from their homes, and therefore, the
access to market information and opportunities for trades could be limited. The other factor probably is that in the light of the uncertainties there could eb a reluctance to unwind positions or initiate fresh positions. Fixed income, by its very nature, provides the holder of the instrument a coupon on a daily basis, and therefore, any accrual higher than the overnight rate is considered a better bargain when the markets are not taking a specific direction as such. While the liquidity surplus continues, there will be higher amounts of primary issues coming from both central and state governments, and also some big issues coming up from larger corporate groups.
7. Portfolio Positioning
The advisory that we have been giving in the fixed space over the last one year has been – do not go deeper into credit or longer into duration. This advisory remains intact. We expect pressures at the long end of the curve mainly arising from the primary issues from the government, and also due to some potential supply from corporates. As we progress further into the financial year, concerns regarding the widening fiscal deficit is bound to catch up, though at this juncture due to the unprecedented situation, it may not come to the forefront. This may also be negative for the elongated securities. But the gamechanger could be overseas participation in the domestic markets and it is something that may more time. Inflation will remain subdued and more or less in the band which the RBI has set for itself for regulation, and ample liquidity, most of the time, would help keep the short end rates stable to lower. Any upside risk to short term yields would be limited.
The earlier recommendations on PSU and Banking Debt Funds, and select corporate bond funds, and short-term funds, remain unchanged. Details of recommended products, scheme-wise, by way of individual product notes will be issued separately.