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Stage looks set for lower bond yields

LiveMint logoLiveMint 25-05-2014 Lisa Pallavi Barbora

Over the past few months, we have seen a lot of euphoria in the equity and currency markets—the S&P BSE Sensex has rallied 21%, and the rupee has appreciated 7.2% since February. But bonds have lagged. The yield on the 10-year government security (G-sec) remained above 9% from February till the start of this month. Moving in closer to mid-May, with the election outcome just around the corner, there was an expectation that the 10-year G-sec yield could fall up to 1% if the election outcome was positive. Despite the positive election result, this did not play out

In the past three trading sessions, however, the mood has changed. The yield on benchmark 8.83% 2013 Government security (10-year G-sec) has moved from 8.85% to 8.63%. For fixed income investors, falling yields are an opportunity for enhanced returns. If yields have peaked then the opportunity can sustain for a long period of time.

Is it sustainable?

May has been a decisive month for bond yields. Though it’s mostly been a gradual move, sharp shifts were seen in the last 2-3 trading sessions. This is thanks to positive expectations being built around the new government’s likely fiscal deficit target.

“There is an expectation that the fiscal overshoot may not happen and the deficit number for FY15 might come in at 4% or lower. Thanks to this, the fence-sitters in bond markets are now starting to buy. Moreover, foreign institutional investors (FII) have also been buyers in the past few days,” said Lakshmi Iyer, chief investment officer (debt) and head products, Kotak Asset Management Co. Ltd.

A lower fiscal deficit target eases the government’s borrowing programme and hence, the subsequent supply of bonds in the market goes down. The expectation of improved demand–supply dynamic has pushed yields lower. Bond yields are inversely related to prices and lower yields mean higher prices, or, in other words, a rally.

“Yields across government securities have moved lower on the expectation that the fiscal deficit, currently pegged at 4.1% of GDP (gross domestic product) in the interim Budget, would be contained by the new government. The measures are expected to be delineated in the Union Budget in July. There is a feel good factor in the bond markets driven by expectation of fiscal deficit control, FII purchases in debt and buoyant response to government borrowing auctions,” said Joydeep Sen, senior vice-president, advisory desk, fixed income, BNP Paribas Wealth Management.

But it may be too soon to call this recent move a sustained rally. “The move is likely to be an interim one rather than a sustained rally since one of the biggest factors, inflation, is yet to fall below the RBI’s (Reserve Bank of India) target. We need to wait and watch whether the RBI governor will continue to be hawkish in his next review due in June,” said Sen, adding that the benchmark 10-year G sec is expected to trade in a range of 8.55-8.85% in the near term, till the presentation of the Budget.Paras Jain/Mint

Inflation and repo rate

One of the biggest factors that impact yields is the monetary policy decision on interest rates. More recently, the RBI has been using the repo rate to manage inflation rather than growth. The repo rate increased from 7.5% in September 2013 to 8% by January 2014; this was against the expectation of most market watchers and analysts.

Bond yields followed suit and started rising from levels of around 8.5% in September 2013 for the benchmark 10-year G-sec to a recent peak of around 9.1% in April this year. Now, even though inflation has reduced, it is still higher than the RBI’s target for consumer price index (CPI) inflation of 8% by January 2015. Moreover, in the near term, there are risks that could take the current CPI-linked inflation even higher.

“There is uncertainty around the El Nino effect on monsoon and, subsequently, on food inflation,” said Rahul Goswami, chief investment officer–fixed income, ICICI Prudential Asset Management Co. Ltd. A higher inflation might prolong the start of a rate easing cycle, which, said experts, may happen after January 2015.

So, for the time being, the immediate up-move in bond yields has most likely raised the floor rather than change the direction of yields. In other words, if the 10-year G-sec yield was trading in a range of 8.8-9% a few weeks ago, it may now trade at 8.6-8.8%. “For a sustained downward trend in yields we need policies that support a low inflationary scenario,” said Goswami.

Until inflation is within the RBI’s comfort zone, the repo rate is unlikely to fall, and unless that happens, the yield curve will not see any sustained moves lower. “A secular downward move will not happen till the repo rate is at 8%. For the time being, we might see a range bound trade of 40-45 basis points in yields (for 10-year G-sec),” said Iyer.

What should you do?

Market yields may no longer be at a peak but they are still high with lower risk premium from here on. The 10-year G-sec yield was 7.15-7.25% in May 2013, when CPI inflation was much higher. The difference between that time and yields today is was in expectations. At present, the uncertainty remains and whether a decisive move in yields will come in the next 6, 8 or 12 months, is anyone’s guess. But the stage is set and risk premiums are coming down in fixed income markets.

In the past one month or so, as yields slowly eased off, annualized returns from income funds are in double digits. You can now start building exposure to income funds with long duration. Such funds invest in long maturity bonds but they make for an opportunistic investment and you have to consider the risks. “The risk for running high duration are spike in inflation, higher (than expected) fiscal deficit, US treasury yields firming up at a fast pace and faster than expected rupee depreciation,” said Rajesh Iyer, head-investment advisory services and family office, Kotak Wealth Management.

This kind of investing is not for everyone. At present, you will have to be patient and remain invested for 12-18 months for expected gains to come through. Pick income funds not on the basis of past performance but on the basis of portfolio duration and fund manager’s view on direction of bond yields.

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