The bond market selloff of late September continued
in October. During the month, the 10-year benchmark government bond yield
(Gsec) surged 17 basis points from 6.22% on September 30, 2021, to 6.39% on
October 29, 2021.
Since September 20, 2021, the 10-year
government bond yield has moved up by a cumulative 24 basis points. At the
shorter end, the impact was even more pronounced as yields on 1-3 year maturity
government bonds jumped by about 35-40 basis points during the same period.
Much of the selloff can be attributed to two
developments – (1) a steep rise in crude oil price and (2) a normalization of
liquidity operations by the RBI.
The crude oil price has been rising for the
last two months due to the pick up in global demand and restricted supply by
the oil producers’ cartel – the OPEC and Russia. The Brent oil price has jumped
by ~18% in the last two months and currently hovering near its 2018 peak of USD
86/barrel.
If supply is not raised quickly, crude oil
prices will remain under pressure which poses a risk for Indian bonds.
The RBI has been normalizing its liquidity
operation since the start of this year with staggered re-introduction of variable-rate
term reverse repos (VRRR). This was on expected lines and was more or less
priced in the market.
However, total liquidity absorption under VRRRs
increased significantly during the last month, which in turn led to a sharp
reduction in the overnight surplus liquidity with banks. At the same time
cutoff yields on the VRRR auctions also moved higher between 3.75%-3.99%.
The sharp jump in the money market rates
inflicted to the front end of the bond curve and pushed yields higher. There is
also an expectation of a hike in the reverse repo rate in the upcoming monetary
policy review in December 2021.
Although the macro backdrop is
unfavourable, valuations at both the short and long end of the curve have
improved significantly after the sell-off. We particularly like the 3-5 year
segment of the government bond market which in our opinion, is already pricing much
of the liquidity normalisation and a start of rate hiking cycle by end of this
year. Given the steep bond yield curve, 3-5 year bonds offer the best roll down
potential as well.
At the longer maturity segment,
current yield levels look good from a perspective that the terminal repo rate
in this cycle may remain much below its pre-pandemic normal level. However, we
are restricting exposure to the longer segment due to risk from the rising
crude oil prices and the absence of assured RBI buying.
Currently, a bulk of the QDBF portfolio
is positioned in the 2-5 year space which is reflective of our aforesaid view
on the bond market.
In the current juncture, we
believe a combination of liquid to money market funds to benefit from the
increase in interest rates in the coming months; along with an allocation to
short term debt funds and/or dynamic bond funds with low credit, risks should
remain as the core fixed income allocation.
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or mutual fund units for the reader. The article has been prepared on the basis
of publicly available information, internally developed data and other sources
believed to be reliable. Whilst no action has been solicited based upon the
information provided herein, due care has been taken to ensure that the facts
are accurate and views given are fair and reasonable as on date. Readers of
this article should rely on information/data arising out of their own
investigations and advised to seek independent professional advice and arrive
at an informed decision before making any investments.
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