As Budget 2022 sledgehammers with high borrowing, bond market fumes

Representative image.

Hell hath no fury like a bond market scorned.

If you thought the bond-yield surge of February 1 was a hissy fit set off by the record market borrowing announced in the Budget, think again. Bond yields surged another 10 basis points to an over two-year high on February 2 and it doesn't seem to be over yet.

HSBC analysts expect the 10-year yield to rise to 7.5 percent by the second quarter of 2022 and to 7.8 percent by the end of the year.

At 6.89 percent yield, the corresponding price of the 10-year benchmark bond maturing in 2032 is Rs 97.52. All those investors who picked the paper at the auction about four weeks ago after paying Rs 100 that corresponds to a yield of 6.54 percent are losing money. Bond prices move inversely to bond yields.

To start with, bond traders were expecting the market borrowing of the government to be elevated for FY23. But the Rs 14.95 lakh crore gross borrowing has come out of the blue.

Also read: Budget 2022: Bond market gets a steep bill from government

At that level, the borrowing is at a record high and 43 percent higher than the current year. In fact, the government ended up borrowing less even in FY21, the year worst hit by the coronavirus pandemic. That year also saw a big hit on tax revenues for the government and the biggest jump in fiscal deficit.

To be sure, a part of the market borrowing would go towards repayment of earlier borrowings. Such repayments are budgeted at Rs 3.76 lakh crore and adjusted to them, the net bond supply would be Rs 11.2 lakh crore. Even this is 32 percent higher than the current year’s net borrowing.

The upshot is that bond investors would be left with a huge bond pile to absorb. The pain for the bond market doesn’t end here.

The sweetener of inclusion in global indices doesn’t seem to be coming forth. Bond traders were expecting the government to announce an exemption of capital gains tax for bonds in the Budget. This would have hastened the process of inclusion in global bond indices.

Also read: MC Interview: DBS Bank senior economist Radhika Rao on why yields shot up on Budget day

Index inclusion has many conditions, one of which is the tax exemption. Absent this, the inclusion process looks long drawn now. That means foreign investors have little incentive to put their dollars into India’s bonds.

The pool of buyers had already reduced with the Reserve Bank of India (RBI) turning a net seller of bonds of late.

“Amidst all the encouraging news, the Budget was silent on any tax tweak to enable the inclusion of India bonds on global indices, which was keenly awaited. This disappointed the bond markets as they reeled under the pressure of higher than expected borrowings,” wrote analysts at Bank of America Global Research.

Also read: Union Budget 2022 | A breakdown of the key numbers for FY23

A sharp rise in long-term sovereign bond yields may increase the cost of borrowing for the rest of the economy as well. Corporate bond yields are expected to climb now, making it costly for companies to borrow.

With the RBI in policy reversal mode, loan rates could also be looking up. While rising interest rates won’t hurt the economy immediately, they may start to pinch sooner than later.

What is worse for the government is that its cost of borrowing has surged now. As such, nearly 48.6 percent of its net tax revenues will go towards interest payments on these bonds in FY23.

Also read: Budget 2022 | FM pegs fiscal deficit at 6.4% of GDP for FY23

Interest payments are budgeted at Rs 9.31 lakh crore for the next year and the government has assumed a net tax revenue of Rs 19.35 lakh crore. This interest burden is an unproductive expenditure and a result of past borrowing binges.

The government is slowly entering into a debt trap. It has shot itself in the foot with a record borrowing target.