Fed playing to the script keeps Indian bond yields under check

The US Federal Reserve playing to the script and hiking rates by 25 basis points, kept Indian bond yields under check. The yield on 10-year G-Secs opened marginally down at 6.7 per cent levels.

The US Fed also stuck with its policy of gradually raising rates, penciling in two more quarter-point increase in 2017 and three more in 2018 — their projections remaining unchanged from that put out in December.

While this is likely to keep our bond yields under check, as the market has been more or less factoring in two more rate hikes by the Fed this year, gradual hardening cannot be ruled out.

Near-zero possibility of further rate cuts by the RBI, volatility in foreign flows from the domestic debt market, measured buying of government bonds from domestic institutions and the RBI not conducting OMOs -- buying of government bonds -- at the same pace as last year, will continue to add upward pressure on domestic yields.

Narrowing returns

The relatively higher interest rates in India have always been a big draw for foreign investors. But the spread between the US and India 10-year benchmark bonds has been shrinking over the past couple of months.

With US bond yields currently at 2.5 per cent levels, the spread is around 400 basis points down from historical average of around 550 basis points. Aggressive hike in US rates can see outflows from emerging bond markets, adding pressure on our bond markets too.

On a nominal basis, Indonesia is another country that offers high interest rates on its ten year bonds at 7.3 per cent. Just as in India, inflation in Indonesia too inched up to 3.8 per cent in February. But real returns on Indian bonds are a tad less attractive. With the current CPI inflation of 3.65 per cent, real return on 10 year G-Sec is about 3.2 per cent.

The personal-consumption expenditures price index, which is the Fed's preferred inflation gauge, rose 1.9 per cent YoY in January. The real return in the US works out to 0.6 per cent. If the Fed increases its rates sharply, the rate differential between India and US is unlikely to hold out, driving foreign investors away from our markets.

For now though, the Fed has quelled fears, sticking with its policy of gradual increase in rates.

Lack of appetite

The appetite for government bonds by foreign investors has been waning, as visible in the data put out by NSDL. One way of gauging FPI’s inclination for investments in government securities, is to look at the debt utilisation level.

As of March 14, 2017, FPIs have utilised only 63.9 per cent of their limits to invest in government securities. From January 2017, limit for FPIs in Central Government securities has been revised to Rs 152,000 crore and limit for Long Term FPIs (Sovereign Wealth Funds (SWFs), Multilateral Agencies, Endowment Funds, Insurance Funds, Pension Funds and Foreign Central Banks) in Central Government securities has been enhanced to Rs 68,000 crore.

The limit for investment by all FPIs in State Development Loans (SDL) has been revised to Rs 21000 crore.

After pulling out close to $6.3 billion of money from debt market in 2016, foreign portfolio investors (FPIs) have poured in close to $ 697 million in 2017 so far.

Aside from higher returns, foreign investors also draw comfort from the stability of a country’s currency. The rupee is one of the better performing currencies when compared to other emerging markets so far this year. This can, to some extent, keep outflows from our bond markets under check.

On the domestic front, the aggressive buying of buying of government securities by banks, particularly PSBs, lent support to bond prices last year.

In November, PSU banks were net buyers in government securities to the tune of about Rs 25,900 crore. Private banks too bought (net) around Rs 20,000 crore. In December, the buying spree continued for PSU banks, who made net purchases of Rs 61,000 crore, even as private banks turned net sellers.

However in January, both PSU and private banks were net sellers to the tune of Rs 38,000 crore and Rs 7,200 crore, respectively. After turning net buyers (marginally) in February, banks have once again started selling government bonds this month.

Mixed signals

A mix of domestic and global factors are likely to weigh on bond markets from hereon. While there can be demand for G-Secs by banks because of lack of lending opportunities, limited upside in bond prices, will curtail aggressive buying. Global yields hardening can also leave little headroom for a fall in yields in the domestic bond market.

The yield on G-Sec has now moved 60 basis points above the repo rate (6.25 per cent) — at which banks borrow short-term funds from the RBI.

Bond yields moving above the repo rate in the past has been an indication of rates going up. While a rate hike by the RBI is unlikely at this juncture, if inflation moves up significantly beyond the RBI’s baseline projection, rate hikes could well be on the cards over the medium term.

Bond investors should stay clear of duration calls (betting on rate movements) and instead invest a chunk of their debt fund investments in short-term income funds that carry less volatility in returns.