Falling yields: Don’t jump the gun, choose safety over returns

Arvind Chari

The ‘Visible Hand’ of the Reserve Bank of India (RBI) is clearly having its impact on the Indian bond market. Especially since the credit crisis of September 2018, the central bank has been truly instrumental in shaping the behaviour and the outcome of the market.

This, of course, is not restricted to the RBI. Global central bankers, after the 2008 Lehman crisis, have taken on significant responsibility to counter deflation, recession, debt and currency issues, and its major impact has been on (excess) market liquidity and (suppressed) bond yields.

It is no surprise then that the RBI, faced with a credit crisis and an economic slowdown, has also stepped in with conventional and non-conventional measures to support the economy and revive confidence in the markets.

Between October 2018 and February 2020, the RBI in order to:

1. Support growth: Cut the repo rate by 135 bps (1.35 percent) from 6.5 percent to 5.15 percent as the CPI (consumer price index) inflation remained well below its target level of 4 percent.
2. Move System Liquidity from Deficit to Surplus: Conducted outright Open Market Purchase Operations (OMOs) of nearly Rs 3.1 lakh-crore by buying government bonds, introduced a foreign exchange sell/buy swap to add liquidity to the tune of Rs 70,000 crore, bought ~Rs 4.9 lakh-crore ($70 billion) in outright forex (FX) intervention to manage the rupee and add liquidity to the system. The banking system liquidity now stands at a surplus of about Rs 3 lakh-crore from a deficit of close to Rs 0.4 lakh-crore.
3. Manage government fiscal deficit: Transferred an unprecedented Rs 1.76 lakh-crore to the government as dividend and surplus capital transfer.
4. Manage long-term bond yields: Devised its own version of the US Federal Reserve style ‘Operation Twist’, unable to cut the repo rate further and faced with a surplus liquidity. Through this, the RBI bought longer-term bonds and sold shorter tenor ones in order to get yields on long-term government securities lower, hoping that it would lead to lower yields for corporate bonds in the long run.
5. Drive through monetary transmission: Troubled with the lack of monetary transmission – a term used to denote the impact of surplus liquidity and lower repo rates on the lowering of lending rates -- the RBI mimicked the European Central Bank’s (ECB) Long Term Repo Operations (LTRO) by providing banks cheaper money. It decided to conduct long-term repos with 1- and 3-year tenure of up to Rs 1 lakh-crore at a fixed rate. This should get lending rates lower, but at the same time push down short tenor bond yields.

The bond market has been the biggest beneficiary of all these steps above. According to the Bloomberg Generic yield curve, the 5-year government bond yield is down to 6.24 percent as of February 17, 2020, from 8.07 percent in September-end 2018. The 10-year paper dropped to 6.39 percent, from 8.02 percent, during the same period. For AAA PSU 5-year bond, the yield moved to 6.46 percent from 8.81 percent, and for 10-year AAA PSUs, it fell to 7.25 percent from 8.78 percent.

If you look at 1-year category returns on long-term gilt funds, a majority of them have given double-digit returns, a proof that the yields have fallen after strong capital gains. Similar has been the experience for the Dynamic Bond Fund category. The funds which take active interest rate risks, but keep credit risks in check have been able to post double-digit returns.

However, at the same time, returns of credit risk funds offer a different picture where the 1-year returns of a majority of funds are deep in negative and/or well below the coupon rates. That means price erosion due to spread widening and/or outright default leading to a markdown in bond prices.

So, what’s in store and how should we approach the year ahead?

We do not expect the RBI to be able to cut the repo rate from 5.15 percent, going forward. This will be the outcome of the government allowing food prices to stay high so as to increase farm incomes and revive consumption. That said, the CPI (consumer price index) inflation may hover above the 4 percent target.

The government bond curve up to 5 years yields below 6 percent and that of high quality AAA PSU till 5 years is less than 6.5 percent, lower than bank deposits.  Any further dip in yields depends on more RBI actions and/or other favourable outcomes like fall in oil prices and/or increased demand from foreigners from the proposed inclusion of Indian government bonds in global indices.

We believe that any movement in yields lower is tactical in nature and does not warrant any strategic allocation to long-term bond funds. Although this may not be the end of the bond rally, investors would be better off lowering their return expectations from bond funds, going forward.

Given the expectations of liquidity conditions staying surplus, returns from overnight and liquid funds should remain muted, in line with the repo rate.

There will be recommendations to allocate to credit risk strategies given the fall in yields of government bonds and AAA companies. But, as we have been highlighting for some time, we do not yet see the end of the credit crisis in the bond market despite the RBI’s measures. Investors should be careful while choosing bond funds and should prioritise liquidity and safety over higher returns.

Arvind Chari is the head of fixed income and alternatives at Quantum Advisors Pvt Ltd. Views are personal.