Fixed Income Monthly
Commentary – November 2022
The bond market was range
bound in October 2022. The 10-year maturity government bond was (G-sec) trading
between a broad range of 7.35% and 7.55%.
On a monthly closing basis, the 10-year G-sec settled 5 basis points
higher at 7.45% on October 31, 2022, versus 7.40% on September 30, 2022. In
2022 so far, the 10-year yield has moved up 100 basis points.
Money market rates continued
to move higher with 3 months' treasury bill moving up by 35 basis points during
the month from 6.09% on September 30, 2022, to 6.44% on October 31, 2022. In
2022 so far, the 3-month treasury bill yield is up 280 basis points.
Liquidity conditions
continued to tighten due to increased cash withdrawals and forex sale by the
RBI. Liquidity surplus in the banking system as measured by banks’ net lending
or borrowing under the RBI’s liquidity adjustment facility (Repo, SDF, MSF,
etc.), declined from an average of ~Rs. 760 billion during September to an average
of ~Rs. 35 billion in October 2022. It was around Rs. 7 trillion at the start
of the year.
The global market’s
volatility increased further during October as bond yields across developed
markets moved up sharply by the middle of the month and retraced back partially
by the month end. The 10-year US treasury yield shoot up from 3.83% to 4.24%
and then fell back to close the month at 4.04%. Similarly, the 10-year German
bund yield jumped from 2.1% to 2.41% and then fell back to 2.14% by the October
end.
In the United Kingdom, the
bond market (Gilt) continued to witness extreme volatility since the
controversial tax cut proposal by the UK government in September. Long-term gilt yields had shot more than 130
basis points in a matter of 7 days. It triggered a panic selling by pension
funds due to large losses on their leveraged positions and forced the Bank of
England to announce bond buying to cool off the market.
Later, in October, the
government withdrew the tax cut proposal and instead announce a further tightening
of fiscal policy. Following all the policy flip-flops, the 10-year gilt yield
first jumped from 3.2% on September 19, 2022, to 4.5% by mid-October and then
fell back down to 3.5% by end of the month.
Turbulence in the gilt
market was though started by a bad fiscal policy, the market reaction was
compounded due to a lack of market liquidity and investors’ nervousness given
the fast pace of rate hikes around the developed world.
Investors have been
complaining of a similar lack of liquidity in the US treasury markets. In Japan
also trading dried up completely in the 10-year benchmark bond for four
consecutive sessions.
With these incidents, financial
stability concerns have resurfaced. There is a worry that the fast pace of rate
hikes in the developed world would further deteriorate the liquidity in the
financial market.
In India, the RBI followed
the expected path and delivered another rate hike of 50 basis points on
September 30, 2022. This took the Repo rate to 5.9% and the SDF rate to 5.65%. Since
April this year, the RBI has frontloaded the monetary policy tightening with -
(a) 190 basis points increase in the repo rate; (b) 230 basis points increase
in the floor policy rate (Reverse Repo/SDF), and (c) reduction in core
liquidity surplus by around Rs. 7 trillion.
The impact of these rate
hikes and liquidity tightening will be seen in the real economy over the next
3-4 quarters. Given the significant frontloaded tightening in monetary
policy and the fragility of economic growth, there is a case for the RBI to
slow down or even pause.
Some of the MPC (monetary
policy committee) members also presented a case for the RBI to adopt a more
calibrated approach going forward and warned of the harmful effects of
overtightening in an environment where the growth outlook is very fragile.
In our opinion, the RBI will
be more data-dependent and will likely slow down the pace of tightening. The
Repo rate may peak somewhere between 6.0%-6.5%.
The bond market is already
pricing for a terminal repo rate of 6.5%. So, another 25-50 basis points repo
rate hike will not impact market prices in any material way.
We believe, the peak of
central banks’ hawkishness is now behind us. It is a time we should look beyond
the market noises and spot the emerging opportunities in the bond market.
After the recent sell-off,
bond valuations have improved. Currently, the 3-5 years government bonds are
trading at a yield of between 7.30%-7.45%. This is more than 140 basis points
above the repo rate of 5.9%. The long-term average of this spread in a
tightening interest rate environment is around 80-90 basis points.
As the monetary policy
stabilises, the yield spread between long-term bonds and the repo rate should
compress. So, we see limited upside on yields from here. Even in terms of real
interest rates, the entire bond yield curve is now trading at a yield above the
expected CPI inflation.
We expect bond yields to
move sideways in a tight range with the 10-year G-sec yield trading between
7.2%-7.6%. While Short term money market rates will move higher along with the
policy repo rate.
Considering the
duration-accrual balance, the 3–5-year segment remains the best play as core
portfolio allocation. However, valuation at the longer end bonds up to 10 years
have also turned attractive after the recent sell-off.
We suggest investors with a 2-3
years holding period should consider adding their allocation to dynamic bond
funds to benefit from higher yields on medium to long-term bonds.
Dynamic bond funds have the flexibility
to change the portfolio positioning as per the evolving market conditions. This
makes dynamic bond funds better suited for long-term investors in this volatile
macro environment.
Investors with shorter
investment horizons and low-risk appetite should stick with liquid funds. With the
increase in short-term interest rates, we should expect further improvement in
potential returns from investments in liquid funds going forward.
Since the interest rate on
bank saving accounts are not likely to increase quickly while the returns from the
liquid fund are already seeing an increase, investing in liquid funds looks
more attractive for your surplus funds.
Investors with a short-term
investment horizon and with little desire to take risks should invest in liquid
funds which own government securities and do not invest in private sector
companies which carry lower liquidity and higher risk of capital loss in case
of default.
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