By Pankaj Pathak
In the last month, the bond market stood firm against persistent negative shocks. The government breached its FY20 fiscal deficit target by Rs 1.8 trillion (0.80% of GDP). Market borrowings for FY 2020-21 increased by over 50% (Rs. 4.2 trillion). Consequently, Moody’s downgraded the sovereign rating of India just as crude oil price jumped by over 50%.
Despite this, bond yields remained in a tight range and even declined marginally by the month end, when the RBI cut the Repo Rate by 40 basis points. The 10-year benchmark government bond (old security) yield declined by 9 basis points in the month to trade around the 6.0% mark.
Underlying macro variables have turned against the bond markets, especially for the longer maturity segment. Rate cutting cycle is near to its end, government’s fiscal position has worsened considerably and there is a risk of a sovereign rating downgrade.
The combined fiscal deficit of the central and state governments is likely to widen to around 11% of GDP in FY 2020-21, compared to around 7.6% in FY 2019-20 and around 6.9% in FY 2018-19. Given the weak growth and expected slower recovery, tax revenues might remain low in years to come. This will ensure elevated levels of fiscal deficit well beyond FY21.
To fund this increase in the fiscal deficit, government both at centre and state levels will have to borrow a lot more from the bond markets than the usual trend. This could exert significant upward pressure on the bond yields (downward pressure on bond prices) over the medium term.
Part of this expected fiscal deterioration is already reflected in the high-term premiums (long maturity bond yield over Repo rate). The difference between the 10-year government bond yield and the Repo rate is now at 175 basis points, compared to its long term average of around 80 basis points.
Indian interest rates at historic lows
(Source – Bloomberg, Quantum Fixed Income Research)
Only based on this spread, the longer maturity bonds look attractive. However, we need to remind ourselves that prices of longer maturity bonds are more sensitive to interest rate changes than shorter maturities. For example, with a 100 basis points increase in 10-year bond yield its price would fall by around 7.5%; while for a similar increase in yield of 3-year bond its price would fall by only 1.8%.
We now see a higher probability of bond yields (market interest rates) going up than down. Additionally, there is also a risk of India’s rating downgrade below the investment grade. In our opinion, the risk-reward is unfavorable for the longer maturity bonds. Nevertheless, the shorter maturity bonds (up to three years) might remain supported by the easy liquidity condition.
Portfolio Recommendations and Strategy
Based on this view, we have reduced the maturity profile (lowered the interest rate risk) of the Quantum Dynamic Bond Fund. Currently, the portfolio is concentrated in up to 3-year maturity government bonds and is holding higher than usual cash which can be deployed if interest rates move up.
We understand the economy and markets are currently adjusting to an unprecedented shock. Thus, any forecast is susceptible to changes arising from policy responses from the government and the RBI and changes in global markets. We will remain vigilant of these developments and review our outlook as and when new information comes. Nevertheless, it would be prudent for investors to be conservative at such times of heightened uncertainty.
We advise investors to stick to debt funds with lower maturity and good credit quality. While investing in debt funds, investors should keep the market risks in mind. Investors with low-risk appetite should stick to liquid funds to avoid any sharp volatility in their portfolio value.
Given the excess liquidity situation, which we expect to continue, returns from overnight and liquid funds will remain muted. However, in the current uncertain times, investors should live with lower returns and should prioritize safety and liquidity over returns.
Credit Crisis is not over yet
The corporate debt market (for lower-rated debt) has been under stress and was lacking liquidity even before this deadly virus hit us. With the economic uncertainty caused by the Covid-19 and the nationwide lockdown things got even worse.
The lockdown has significantly impaired the debt servicing capacity of many companies and individuals who have lost a significant chunk of their income. Even after the lockdown is lifted, demand for goods and services would remain below what it was pre-Covid and many of workers may remain unemployed. This could create a negative spiral in the credit markets. We see a higher risk of rating downgrades and defaults in the next two years.
In this scenario, it would be prudent for investors to avoid excessive credit risk in their debt exposure. Investors also need to remember that credit and liquidity risks are an inherent characteristic of debt investments, albeit difficult to identify in normal times. The continuing crisis in the debt mutual fund space is a direct outcome of ignoring these risks for a very long time.
(Pankaj Pathak is fund manager, fixed income, Quantum Mutual Fund)