It was a negative and volatile week for the bond markets, which was a consequence of RBI’s steps of trying to prevent rupee from further depreciation. Overnight rates shot up by 200 bps, Certificate of Deposit (CD) rates increased by 175 -225 bps, and ten-year government bond yield was up by 60 bps. Subsequently, yields are off those highs now- led largely by value buying and little bit also by "perceived dovish" statements by US Fed chairman Ben Bernanke.
Subsequently, the T-Bill auction was a failure with RBI rejecting all the bids and in-fact the subsequent Open Market Operation (OMO) also witnessed a muted demand. However, the Friday auction was reasonably well received by market and the devolvement on Primary Dealers (PDs) was only 35 billion, with 115 billion being taken up in bidding, albeit at a higher cost of borrowing to government.
Admittedly, RBI move has hurt the bond market more than it has helped the currency market. Infact, RBI may have to recoup Forex reserves rather than hike rates to restore the confidence in the INR, which is extremely crucial for INR stability. The import cover has halved to 7 months-1996 levels-in last few years and at least 10 months import cover is needed for INR stability. The current RBI tightening will not have a significant impact on the INR because parity-driven theories do not, in reality, work very well for India. Reason is simple-US $ 250 billion FII equity portfolio, which responds to growth, is much larger than the US $35 billion FII debt portfolio, which responds to rates. However, current measures have been unable to trigger any substantial appreciation of the INR, hence we feel that follow up tangible measures are required.
An NRI deposit scheme/off shore bond issuance by quasi government companies could be on the cards. If that happens-a combination of current high yields and a perceptibly stable currency would lead to a reversal in the current yields. Also, a large off-shore NRI deposit scheme/off shore bond would reduce the domestic supply pressure.
That said the bond market volatility is high and will stay high for a while. Investors will have to look forward as the damage to the markets has already been done and this could be a period of profitable investing. RBI’s actions being temporary rather than permanent in nature, this may not be an appropriate time to fully exit bond funds. The rupee volatility will keep the central bank hawkish but if it finds that keeping liquidity tight in the system will not have any lasting effect on INR levels the RBI will relax its position sooner than later. RBI may not raise repo rate in its 30th July policy review-unless its forced by further worsening in forex markets, and also by the fact that if it had wanted to signal a change in policy stance it would have raised the repo rate on Monday itself and that would have had the same effect as the liquidity tightening measures that were taken. However, given that market sentiments are weak, there will be a tendency to worry about rate hikes and that will be taking a toll on market sentiments and hence there may not be a sustainable one-sided rally.
Investors with only longer term view should take advantage of this short term uncertainty. With current yields up by 80-85 bps from the lows seen in May 2013, gains will be much higher going forward with risk reward ration being favourable at current levels than what it was before the RBI action. The spike in bond yields are seen temporary rather than permanent, the long term view on the interest rate is still positive and has not changed. However volatility will be high for a while and investors will need to be patient and have ability to withstand uncharacteristic volatility.
The author of the article is Fund Manager – Debt at Peerless Mutual Fund