Moneycontrol
Aug 28, 2017 05:18 PM IST | Source: Moneycontrol.com

COMMENT: Should bank investors worry about volatile G-Sec yields?

Conventional wisdom suggests that there should be a strong negative correlation between the change in Bank Nifty and the yield on the ten-year G Sec. To put it simply, if bond prices rise (and hence bond yields fall), banks should be gaining in their G Sec portfolios.


After the release of the GDP data, the Street expressed its happiness with an uptick in both the Nifty (0.75 percent) and the Bank Nifty (0.9 percent). A stronger growth outlook does augur well for the banking sector, reeling as it is under anaemic credit growth. So did banking stocks completely ignore the signals from the 0.8 percent increase in yields of the 10-year Government Securities?

Conventional wisdom suggests that there should be a strong negative correlation between the change in Bank Nifty and the yield on the ten-year G Sec. To put it simply, if bond prices rise (and hence bond yields fall), banks should be gaining in their G Sec portfolios.

The positive impact on earnings in turn should support a rally in Bank Nifty. So if bond yield falls, Bank Nifty should rally and vice versa.  How should investors read the conflicting signals now?

Since the February pause in the Credit Policy, yields have been heading north on expectations of interest rates firming up or at least not declining in the near future. The latest positive surprise from GDP at home and Trump’s renewed pledge to step up infrastructure thereby propelling a rally in commodity prices have reinforced the case for a temporary pause in interest rate cuts. The yield on the 10-year G Sec reacted likewise yesterday. Should investors worry about their position in fundamentally strong banking stocks?

The correlation between the bond yield and banking stocks stems predominantly from the investment book of the banks. In India, banks are mandated to keep 20.5 percent of their Net Demand and Time Liabilities (NDTL) as Statutory Liquidity Ratio (SLR) that also helps the government in meeting its borrowing targets. A part of the Government Securities (G Sec) is kept in the ‘Available for Sale’ and ‘Held for Trading’ categories – tactically to benefit from movement in yields.

In the past one year, the relation was especially relevant as saddled with bad assets and hence higher provision, banks found succour in trading gains. While G Sec yields declined 9 percent, the Bank Nifty rallied 44 percent. Correlation analysis of the daily movement in G Sec and Bank Nifty over the past one year suggests a weak negative correlation (-0.003) over the entire one-year period. So the inverse relationship doesn’t hold at all times. To put it simply, banks do not necessarily underperform when rates are rising and vice versa.

Interestingly, the negative correlation between movement of Bank Nifty and G Sec Yield holds only at certain times, typically around the time any rate action is expected from the RBI. In the past one year, there were six bi-monthly policy meetings of the RBI. We examined the correlation between the Bank Nifty and G Sec Yield over seven trading sessions in and around the policy announcement. The correlation coefficient is significantly negative and hence the inverse relation is valid only when street expects a rate action, otherwise this relationship doesn’t hold.

If we carry out this analysis over longer trading sessions (14 trading sessions) the relationship weakens considerably. This leads to the conclusion that the Street follows the movement in G Sec yield like a hawk only when there is a heightened expectation of rate action and the inverse relationship wanes over a period of time. Investors should evaluate their positions in banking stocks on the fundamental merit of the company and not get carried away by the short-term noise.
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