Budget 2017: Limited upside in bonds

The recommendations of the Fiscal Responsibility and Budget Management (FRBM) Committee report released recently kept debt markets on tenterhooks, as it made a case for providing the Centre with some flexibility on the fiscal front. It was for this reason that bond markets heaved a sigh of relief, when the Finance Minister stood his ground and kept a tight leash on fiscal deficit. Giving the FRBM committee’s recommendation — to move from a fixed to a range-based fiscal deficit target — a go by, the Budget pleased bond markets by retaining a prudent fiscal policy.

But while this is good news, bond markets are unlikely to rally significantly from here-on. In fact, there are now chances that the RBI will follow the Centre’s suit, in pursuing a prudent monetary policy, amid rising uncertainties in global markets.

The good After achieving its 3.5 per cent target for 2016-17, the Finance Minister chose to follow a prudent fiscal policy, upping its fiscal deficit target only marginally to 3.2 per cent of GDP for 2017-18, from the 3 per cent fixed earlier. While the revenue and expenditure figures for the next fiscal appear realistic, uncertainty in growth and downside risks to the Centre’s nominal GDP growth estimate may rankle the fiscal deficit ratio.

That said, lower-than-expected market borrowings have come in as a key positive for bond markets. The gross market borrowing stands at ₹5.8 lakh crore for 2017-18, almost flat from the previous year’s ₹5.82 lakh crore figure. The net borrowing at ₹4.23 lakh crore is also only a marginal 4 per cent up from the previous year. This should keep yields under check.

No big rally Interest rates have been on a free fall in 2016. The RBI’s rate easing, its decision to move to a liquidity neutral regime and the more recent demonetisation drive by the Centre, triggered the unexpected fall in rates. While the need to stimulate growth in the economy, not to mention sanguine inflation trends, will lead to the RBI persisting with its accommodative stance, rate cuts will be limited. The possibility of the US Fed turning aggressive with its rate hikes continues to hang over our heads like the sword of Damocles. Also, if liquidity continues to be ample in the system after currency flow normalises, the RBI may not conduct OMOs (buying of government bonds) at the same pace as last year, capping the fall in bond yields. Hence, rates on long-term government bonds are unlikely to fall substantially from hereon.

Bond investors should invest a chunk of their debt fund investments in short term income funds that carry less volatility in returns. There is a higher possibility of upside on the shorter end of curve given the surplus liquidity in the system.