Bonding with the Budget
If it maintains fiscal prudence, the bond market could turn bullish
“The safest way to get decent returns is via mutual funds.” I’ve heard versions of this statement from half-a-dozen friends in the last year. Most of them are invested in debt mutual funds as well as diversified equity funds. It’s true that there is no safer way to get a decent nominal return. A bank fixed deposits offers much less interest. Real estate is in the doldrums. Gold has been almost flat through 2017. But that safety is relative. Everyone understands that equity funds carry risk but debt mutuals can also suffer loss of capital.
Mutual funds trade debt. They specialise in specific categories and tenures. The risks and returns in each category/ tenure are different. In government debt, default is very unlikely. Sovereign debt is also very liquid – it's considered as good as cash. Interbank money-market trades are also safe, very liquid and short-term. Corporate debt varies a lot in safety and liquidity.
The short-term money market is almost zero-risk but low-return. There is a chance of losing money in every long-tenure category. If a debt fund makes the wrong calls while trading, it can lose money, even in ‘zero-risk’ sovereign debt.
The basic insight required to trade debt is simple. If interest rates are going to fall across the tenure of a given instrument, that instrument will rise in value. Vice versa, if interest rates are likely to rise across that tenure, the instrument will lose value.
To take a basic example, say a 364-day Treasury Bill (T-Bill) is auctioned at 6.52 per cent. This means it has been bought for ~93.88 and it can be redeemed for ~100, a year later. The next day, the Reserve Bank of India (RBI) cuts the policy rate by 0.25 per cent. Now, it is likely that the yield will drop, say to 6.35 per cent. That means the T-Bill can be sold in the market for about ~ 94. This capital gain annualises to a handsome return.
There are other important factors, of course. Tight or easy conditions in the money market can occur for temporary periods. The profile of a corporate, and its ability to service debentures, or the likelihood of default, is also important. Good managers track those things.
But, the first basic variable is interest rate trends. A falling interest rate will bring capital gains, while a rising rate may lead to capital losses. Now it’s up to the fund managers to figure out which way rates will trend and that of course, is no easy task.
Interest rates vary alongside the RBI-determined twinned policy rate: The repurchase or repo rate, at which it lends money to banks and the reverse repo at which it borrows money from banks, with a known spread between those two rates. The government borrows money by issuing Treasury Bills or bonds, usually at a yield a little higher than the repo rate. Corporates borrow at a premium to the sovereign rates, with the premium depending on credit rating and the ability to negotiate.
When rates trend down over an extended period, it is possible for many debt funds to make money off the same instrument. Each time the rate is cut, somebody sells off an existing high-yield instrument and makes capital gains. Even when rates are hiked, a well-managed fund can make money by selling off its portfolio selectively, accepting initial losses and buying new higher-yield instruments which it will hold to make an eventual gain. But this sort of action is more difficult to time and requires great skill and luck.
Bond yields have been rising for quite a while, because government borrowing has expanded. The RBI has held the policy rate unchanged in the last two reviews. It is likely to hold the rate unchanged in February, since inflation is rising. Yield curves have flattened. The yield on the 364-day bill is 6.52 per cent while the 10-year Bond is just 7.55 per cent. The difference is low, given the nine-year gap in tenures.
If this trend continues, any debt fund trading longterm instruments may face capital loss. So that's a category to avoid until the Budget and the next RBI review of February 6-7. If the Budget is inflationary, the bond market could go very bearish and badly impact debt funds. But if the Budget maintains fiscal prudence, the bond market could go bullish again.