Is the Bull Market in Bonds Over?
Written on Friday, February 10, 2017
By Alok Agarwala - Senior VP and Head - Investment Analytics
The Reserve Bank of India, in its 6th bi-monthly policy review (2016-17)on Feb 08-2017, held policy rates unchanged, contrary to market expectations of a 25 bps rate cut. What spooked bond markets was, however, the change in monetary policy stance from “Accommodative” to “Neutral”. 10-year G-Sec yields have risen by 40 bps in two days in response to this change in stance.
It is a mystery why RBI chose to turn hawkish amid- 1. Slowing growth, 2. Falling inflation, 3. Fiscal prudence in Budget 2017, 4. Weak balance sheets of PSU Banks, 5. Dismal credit growth and a 6. Comfortable Macro Economic situation.
It would have been still fine if rates weren’t cut. But to change policy stance from 'Accommodative' from 'Neutral'? What led to this sudden hawkishness?
Does RBI feel that global financial market volatility is likely to spike or does it want to build a forex reserve war chest for the future? Does it expect inflation to shoot up in near future due to rising global commodity prices (Oil)? or a domestic supply shock due to demonetization?
Too many questions and too few straight forward answers. Let us try to see each point.
Does it feel that global financial market volatility is likely to spike?
The outlook for global financial markets has changed post US Presidential Elections. Markets fear increased protectionism in the US may impact global trade and growth, resulting in trade wars and conflicts which may give rise to risk aversion. A fiscal expansion in the US to accelerate growth, higher infrastructure spending in China and increasing Geo-Political conflicts may impact commodity prices resulting in higher inflation and interest rates. Oil, base metal, and food prices have already started moving up. With the US investor heavily loaded with bonds (mostly junk category) and US Banks’ ability to buy bonds impaired by regulations post-2008, a sharp rise in bond yields and resultant sell-off has the potential to trigger another global financial crisis.
Does it want to build a forex reserve war chest for the future?
The best way to protect against a global financial shock is to build a strong forex reserve war chest to support INR in times of need and to have a higher cover for imports (presently at about 11-12 months, sufficient, but not very comfortable in times of crisis). In such a situation, it is important to ensure that there is no mass exodus of foreign capital. Higher bond yields, low currency volatility, and a wide yield spread reduces chances of such an exodus. Moreover, with a chronic current account deficit, capital account inflows are the only way to shore up forex reserves.
Does it expect inflation to shoot up in near future?
One should not get too optimistic looking at latest CPI Inflation readings. Sub 4% CPI inflation is largely attributed to a crash in prices of perishables (vegetables, etc) post demonetization and a high base effect. At best, this disinflation is temporary and transient. What is more worrying is, and we have been highlighting this in our last few monthly communique, that Core CPI (headline minus food and fuel inflation) has remained sticky around 5%. With energy, base metal and food prices rising across the globe, this sticky Core CPI inflation is worrying. Also, most people are focusing on demand destruction after demonetization. Very few notice the possibility (though very remote) of supply destruction in the MSME & unorganized sector. If this happens, Core inflation is likely to remain sticky for longer than most of us expect.
To put things into perspective
RBI has cut repo rates by 175 bps since January 2015 and maintained an “accommodative” policy stance wherein system liquidity was moved from deficit to surplus mode. 10-year G-Sec yields in the same period have fallen by 180-190 bps from the peak. Despite this, banks have responded with lending rate cuts of merely 80-90 bps and that too after considerable moral suasion and regulatory push in the form of MCLR. Base rates of most banks are still down by only 70 bps from the peaks despite single-digit credit growth since April 2015. Even after the windfall deposit and liquidity gains from Demonetization, banks have failed to bring down interest rates effectively to pump up credit growth. Their SLR holdings continued to mushroom in the meantime and rose to 26-28% of deposits. This has resulted in a lot of borrowers resorting to capital markets directly to raise capital. RBI has repeatedly highlighted the banks’ failure to bring down lending rates despite a conducive environment.
The recent policy action (or inaction) and change instance have made one thing clear - the recent rate cut cycle has ended. Going ahead, only a sharp collapse in growth or a sharp downside in inflation can start the cycle back. Both the RBI and the Government have done enough. The onus is now on banks to mend their ways, improve their systems and bring down lending rates so that capital is available to the productive sectors of the economy.
In this scenario, it is imperative for investors to shift away from long duration as the risk reward is extremely poor. The accrual strategies provide a much better risk reward with 1/3rd of duration risk and higher “yield to maturity” (YTM) as compared to Long Duration strategies. The gap in YTMs of long duration and accrual strategies is 125-150 bps per portfolios at the end of Dec 2016. With the recent spike in G-Sec yields, this should have moderated to 100-125 bps. Coupled with a lower interest rate risk, this still presents an attractive risk reward. A simple measure shows that over a 3 year period, long bond yields will have to fall by 0.75-1.00 % (assuming that yields of Accrual strategies don’t fall) to generate enough mark to mark gains to make up for the difference in YTM, not to mention the associated volatility that it shall carry. This seems improbable in the current scenario.
The bull market in bonds seems to be over for the short term. Going ahead, investors shall chase higher yields. With the supply of corporate bonds remaining low due to low investment demand, and, demand for corporate bonds remaining high due to investors chasing yields, the corporate bond spreads should narrow. As demand improves and corporate earnings rise, we should see improved balance sheets and credit rating upgrades for most. This would narrow spreads further, opening up the possibility of limited mark to market gains in accrual strategies to add to the higher YTMs. Overall, the accrual strategies seem to be the best bet for Fixed Income investors in the evolving scenario.