Debt markets have been volatile in recent weeks
The debt markets were rattled last week, after the government announced massive Rs 80,000 crore borrowing plans in Budget 2021 to fund the widening fiscal deficit.
Amid Covid-19 pandemic & expansionary fiscal policies, the budgetary deficit is posited to rise steeply. The government has pegged Fiscal Deficit for FY 20-21 at 9.5% of GDP, sharply above street expectations. This had led to widespread selling in the debt market last week, and the 10-year G-sec yield rose 11 bps on Feb 1 to close at 6.06%.
Markets reacted sharply to the Budget with across the board sell-off. Yields on the benchmark 10-year bond surged 17 basis points in all last week, its biggest jump since April.
RBI steps in to manage volatility
In the wake of rising yields, the RBI has stepped in and announced that it will conduct purchase of government securities under Open Market Operations (OMO) for an aggregate amount of Rs 20,000 crore on February 10. Following the announcement, the 10-year bond yield eased to 6.034% as compared to previous close of 6.071%.
Open market operations refer to the sale and purchase of government securities and treasury bills by RBI. The objective of OMO is to regulate the money supply in the economy. When the RBI wants to increase the money supply in the economy, it purchases the government securities from the market and it sells government securities to suck out liquidity from the system. By purchasing long term bonds, the RBI increases the demand for these and thus pushing up the prices which leads to a fall in yields.
Last week, the RBI kept the repo rate unchanged at 4%. While the RBI assured that government borrowings are likely to be managed without disruptions, lack of any immediate action led to a market sell-off.
Expectations going forward
Debt markets have posted good returns
Indian debt markets have seen a good rally in the last 2-3 years, as 10-year bond yields declined in the last few years. Funds with higher duration have delivered higher capital gains due to yields decline on the back of consistent rate cuts by the RBI.
The benign interest rate scenario was being followed by central banks around the world to promote growth and liquidity. However, with expectations of rising inflation, the RBI may be constrained to cut rates further.
After being stubbornly above RBI's tolerance band of 4% (4% +/- 2%) since April, CPI inflation fell sharply within the RBI's tolerance band to 4.59% in Dec-20, as against 6.93% in November-20.
Overall, while the central bank's policy will remain dovish, inflation projections continue to remain over 4% in FY2022, indicating that, now, there is no room for easing. The RBI is likely to remain on pause mode for most of FY2022.
The current state points to a bottoming of the current interest rate cycle and rates should increase in the long term (1-3 years)
This is exactly what happened post-2008 global recession. During the crisis, RBI reduced interest from 9% to 4.75% in a span of 1 year. Then as inflation picked up, rates started increasing.
Indigrow Recommendation
Invest only high-quality AAA-rated bonds as they have the least risk. In fixed income securities, high risk does not result in higher returns.
There is a significant tax advantage in holding a debt fund for more than 3 years.
For a more than 3-year investment horizon, an investor should prefer short duration (duration < 3) fixed income instruments over long duration. Short duration funds might not give you that extra alpha in the short term (3-6 months) but they are highly likely to outperform long duration funds in the long term. Stick to short duration funds and bonds, and long-maturity bonds as yields are expected to remain volatile in the near future. Further, in the medium-term (2-3 years) the rate cycle is expected to bottom out and move up.
Avoid lump sum allocation and adopt a more staggered approach over the next few months.
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