Bond markets to be under pressure

Rising yields mean bond fund portfolios will be under pressure for a considerable time period.

Rising bond yields and the resulting treasury losses are telling on profitability of banks. Yield on the benchmark 10-year government securities (G-sec) surged 67 basis points (bps) during the third quarter due to fiscal worries. To be sure, these are mark-to-market, or MTM, losses on investment portfolios that can be reversed if the yields correct. But experts think there is a larger concern. “Banks are not actively participating in the market. This is driving up yields,” says Dwijendra Srivastava, who oversees around ` 18,000 crore in various debt schemes as Chief Investment Officer, Debt, Sundaram Asset Management Company.

Once Bitten, Twice Shy

The one-side movement of bond yields since September last year is troubling bankers. Banks are apprehensive of committing more investments as they fear more losses if yields further harden from here.

According to ratings agency ICRA, the yield on the old

10-year government of India security (6.79 per cent GS

2027) had increased by 123 basis points (bps) to 7.72 per cent on February 14, 2018, from 6.48 per cent on September

1, 2017. Moreover, the yield on the new 10-year benchmark G-Sec (7.17 per cent GS 2028) rose from 7.17 per cent, when it was first issued in January 2018, to 7.60 per cent on February 1, 2018, before easing somewhat to 7.49 per cent as on February 14, 2018. “There is clearly a demand-supply mismatch,” says Srivastava. “If government front loads its expenditure, it will also front-load its borrowing. We should not forget that it’s a pre-election year. Banks need to come back (to the market). At the policy level, a lot of engagement will be needed,” he says.

The RBI ensures demand for government paper by mandating banks to maintain a statutory liquidity ratio, or SLR, of 19.5 per cent of deposits. However, in the absence of substantial credit off-take, banks' SLR is 10 per cent more than what they need to maintain. "Commercial banks already hold a significant portion of their assets in the form of central government bonds, and as credit growth picks up and liquidity surplus narrows, the appetite of commercial banks for more government bonds is likely to decline," Goldman Sachs said in a research note dated February 13.

Budget — Broken Promises

So, will credit growth pick up so that banks can increase lending and not park money in government paper? Although private investment is muted, the government is slated to grow its expenditure by 10 per cent in 2018/19. But for this it will have to breach its fiscal promises.

As feared by the bond markets, not only did the government revise the fiscal deficit target from 3.2 per cent to 3.5 per cent of the gross domestic product (GDP) for FY18, it set the 2018/19 target at 3.3 per cent of GDP as against a promised glide path of 3 per cent of GDP. Due to this, the government will have to borrow ` 6.06 lakh crore as against ` 5.8 lakh crore in the current year. For 2018/19, net of redemptions, the figure stands at ` 4.6 lakh crore. For absorption of more paper, the government will have to offer higher interest rates. A rise in yields will depress prices of existing bonds.

“There was no clarity on many fronts since August last year,” says Mahendra Jajoo, who oversees ` 2,000 crore in assets as head of fixed income at Mirae Asset Global Investments (India). “Trends in oil prices and food inflation were uncertain. Goods and Services Tax collections were uncertain. There was a greater worry of government breaching its fiscal deficit target. Macros suddenly turned challenging for India.”

Jajoo is hinting at rising prices of crude oil. In recent months, some global central banks have started tightening. There are also fears of foreign portfolio investors (FPIs) withdrawing from emerging markets like India for safer havens. There are also concerns regarding the strength of the demand for G-secs from banks and FPIs.

FPI Limits

“The signals are that FPI limits will be eased gradually for long-term investors,” says Srivastava of Sundaram MF. At present, FPIs are allowed to invest in central government securities to the tune of ` 2.55 lakh crore; the figure for state government securities is ` 45,000 crore. FPIs have already utilised around 98 per cent of those limits. “The government typically opens up by 5 per cent every year gradually,” says Jajoo of Mirae Asset. The problem with allowing more FPI money is that it can lead to rupee appreciation, affecting exports and hitting the economy. FPIs hate rising inflation, which can mean tighter monetary policies, lowering returns on their bond portfolios.

Inflation and Interest Rates

The RBI’s monetary policy presented on February 7 left the policy rate unchanged at 6 per cent. The overall stance remained neutral. The RBI raised its consumer price infla-

“What will work well now is accrual strategy, staying with shorter duration papers to contain the risk of capital erosion and staying with high quality paper.”