Short end of the yield curve is still attractive

The short end of the yield curve offers attractive returns despite the curve moving down over the last six months. Yields on money market securities and short term bonds have come off over the last five months on the back of RBI cutting the repo rate by 50bps in its April 2012 policy and on the back of easing liquidity pressures in the system.

The levels on one year T-Bills (Treasury bills) and one year CD (Certificate of Deposit) are at 8% and 9.05% respectively as of end August 2012 and have come off by around 45bps and 60bps respectively over the last five months. Government bond yields in the two to five year maturity segment have come off by around 30bps over the last five months and are trading at around 8% to 8.20% levels respectively. Short term AAA rated corporate bonds in the two to five year maturity segment have seen yields come off by 20bps to 25bps since April 2012. Two, three and five year maturity AAA rated corporate bonds are all trading at around 9.20% levels. 

The fall in yields at the short end of the yield curve is due to the RBI lowering the repo rate from 8.5% to 8% in April 2012 and due to the fact that liquidity deficit has come off on the back of RBI bond purchases. Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI has come off from negative Rs 100,000 crores levels to negative Rs 45,000 crores levels over the last six months. RBI has purchased bonds worth Rs 80,000 crores in the fiscal 2012-13 year to date to ease liquidity conditions.

Chart 1. Corporate Bond yield curve movement

 

 

 

 

 

Source: FIMMDA

The outlook for policy rates and liquidity is more positive than negative. RBI is likely to maintain or ease the repo rate in the coming months given that GDP growth for the first quarter of 2012-13 has come in at 5.5% against RBI's full year estimates of 6.5%. GDP has to grow at around 7% levels over the next three quarters if estimates are to be achieved and for GDP to grow at 7% levels interest rates have to come off.

Liquidity is expected to be in deficit in September 2012 given second quarter advance tax outflows and September end demand for funds due to half yearly closing of accounts by the banks. However liquidity is more likely to ease going forward as credit growth could falter in the busy season due to weak monsoons and due to a slowdown in economic growth. Slowing credit growth reduces demand for funds by banks and this is positive for liquidity.

The fact that the Indian Rupee has stabilized at around Rs 55 to Rs 56 to the US Dollar helps bonds at the short end of the yield cure as FII's stay invested in Indian bonds and look to invest further given stable currency. FII's have invested around USD 5 billion in Indian bonds calendar year 2012 to date.

A mix of money market securities and short term bonds will yield around 8.5% to 9% depending on the government bond to AAA rated corporate bond ratio. The yields are likely to be stable with a positive bias going forward given expectations of rate cuts and given easier liquidity conditions.

Investors can invest directly into fixed income securities or invest in short term income funds that invest at the short end of the yield curve. It is advisable to stick to the best credit quality given the rising levels of bad loans and restructured loans in the system. CRISIL estimates that around Rs 325,000 crores of loans are likely to be restructured in 2012-13 and of that around Rs 50,000 crores of loans will turn bad. Investors should not get stuck with bad credits either directly or indirectly through mutual funds.