Debt Market Observer

Quantum Fixed Income October 2023

Geopolitics and Shifting Demand-Supply Balance

Elevated crude oil prices and the ‘higher for longer’ narrative for US interest rates continue to dominate

the investor sentiment in the bond market. Escalating tensions in the Middle East have added to the

prevailing nervousness. It is keeping market participants on their toes. So much so that it took away focus

from some remarkable improvements in the domestic macros and market dynamics.

Before going into the discussion of domestic trends that we are seeing, let’s first explore the issue related

to the recent flareup of geo-political conflict between Israel and Palestine and its impact on the bond

markets.

West Asian Conflict-Lessons from history

Our understanding of geopolitics is no better than anybody else following news regularly. However, based

on the lessons from past conflicts in the region and borrowed wisdom of geo-political experts, we note

following:

 Conflict in Middle East can have a significant impact on the global and Indian economy through

two major channels – (1) crude oil supply/prices, and (2) disruption of global trade route.

 Neither Israel nor Palestine are significant producers of crude oil. Thus, a localized war between

the two might not have any material impact on the global oil supply – keeping prices under

check.

 Direct involvement of major oil producing nations particularly Iran can push oil prices higher,

though experts assign a low probability to this outcome.

 Middle East has three key chokepoints in the global trade route - the Suez Canal, and the straits

of Hormuz and Bab-el-Mandeb. Wider spread of war could pose a threat to global trade routes

which in turn would be inflationary.

Table – I: Conflict Scenarios and Potential Market Impact

Scenarios Market Impact Probability

1. War limited between Iseral

and Palestine

Market neutral, crude oil prices to retrace back over

period

Most likely

2. Major regional Conflict; but

no direct involvement of Iran

or Saudi

Increased Geopolitical risk premium

Crude to remain elevated for extended period

Risk of trade route blockage to put pressure on global

community particularly the US

Upside risk to inflation and bond yields

Low

3. Major regional Conflict with

direct involvement of Iran in

war

Global risk off

Significant upside risk to crude oil prices.

High risk of disruption in trade routes

Significant upside risk of inflation and bond yields

Very Low

In conclusion, potential market impact of the current middle eastern conflict can be categorized as – ‘high

impact - low probability’ outcome.

Debt Market Observer

Quantum Fixed Income October 2023

Till now, Indian bond yields have shown resilience with the 10-year IGB (Indian government bond) trading

almost at the same level as prevailed before the war broke out. While crude oil prices jumped about 10%

in anticipation of broader conflict hurting the global oil supply.

Table – II: Indian Bond yields sowing resilience to geopolitical tensions and rising crude oil

Before the war…

(October 6, 2023)

Current

(October 18, 2023)

Brent Crude Oil price (USD per Barrel) 84.5 92.4

10-year US Treasury Yield 4.81% 4.99%

10-year Indian Government Bond Yield 7.34% 7.37%

INR/USD 83.24 83.1

Source – Bloomberg, Quantum Research; data as of October 19, 2023

We expect the resiliency of the Indian bonds and the rupee to continue supported by strong domestic

fundamentals unless crude oil moves up substantially from current levels.

Fiscal Flexibility

Government’s tax collections have shown a healthy growth in the first half of the fiscal year 2023-24. As

per the government’s press release, direct tax collections for FY24 up to October 9, 2023 have grown by

21.8% compared to same period last year. This is significantly higher than the government’s budgeted

direct tax growth target of 10.5% YoY.

Chart – I: Tax Revenues continue to grow at a faster pace than budget estimates

FY 19FY 20FY 21FY 22FY 23FY 24

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

3,662

4,046

2,845

6,448

7,001

8,039

Net Tax Revenue to Centre

between April to August Period

Source – cga.nic.in, Quantum Research, Data upto August 31, 2023

Debt Market Observer

Quantum Fixed Income October 2023

Non-tax revenues have also shown a remarkable jump over the last year owing to the large dividend of Rs.

874 billion from the RBI. We expect other public sector companies particularly public sector banks to

deliver significant growth in dividend payouts to the government.

In our estimate, combination of tax and non-tax collections could provide government around Rs. 1.5

trillion extra revenues than their budget estimates. Even after adjusting for some shortfall in the

disinvestment target, the government will likely have more than Rs. 1.2 trillion of extra cash this year.

This can be used to reduce taxes on fuel or increasing welfare spending without stretching the

government’s fiscal position. This also opens a possibility of reduction in government borrowing later in

the year.

Collections under various small saving schemes of the government have also shown a robust 50% increase

during April-August 2023 compared to the same period last year. This further boosts the chances for

reduction in government borrowing.

Even without a borrowing cut, demand supply mix in government bonds looks favorable in the

remainder of FY24. The gross and net borrowing in the H2 FY24 is pegged at Rs. 6.6 trillion and Rs. 3.8

trillion respectively. The net bond supply in H2 FY24 is significantly lower than last year’s net issuance of

Rs. 5.5 trillion in the same period.

Going by the past trend, combined demand of top buyers such as banks, insurance, pensions, provident

funds will likely be higher than total supply in the reminder of FY24. These institutions had bought

government bonds worth Rs. 4.2 trillion on net basis between October 2022 to March 2023.

From more medium-term perspective, assuming government follows its fiscal glide path to reduce fiscal

deficit to 4.5% of GDP by FY 2025-26, net supply of government bonds will likely fall by around Rs. 1.6

trillion over the next 2 years bringing it down to around Rs. 10.2 trillion by FY26 from current Rs. 11.8

trillion.

Chart – II: Fiscal consolidation will lead to significant reduction in bond supply over coming years

2022-232023-242024-252025-26

7.0

8.0

9.0

10.0

11.0

12.0

13.0

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%6.4%

5.9%

5.2%

4.5%

Fiscal Deficit and and Bond Issuance

Net Borrowing - LHSFiscal Deficit - RHS

Debt Market Observer

Quantum Fixed Income October 2023

Source – IndianBudget.gov.in, Quantum Research, Data for FY25 and FY26 is based on Quantum

Research team’s estimates

On the demand side, we expect a healthy demand growth from long term investors like insurance,

pensions, provident funds etc. to continue in line with the growth in the nominal GDP. India’s inclusion in

the global bond indices will also be supportive for demand in the bond market.

India will be included in the JP Morgan GBI EM Index starting June 2024 with an eventual 10% index weight

to be reached in March 2025. This is expected to attract USD 25-40 billion of foreign inflows into Indian

bonds over the next 12-15 months.

Read more about the potential impact of bond index inclusion - {Why Soaring Oil Prices Couldn't Dampen

Market Mood}

What about the RBI’s OMO Sales?

Since the RBI governor’s statement that the RBI may conduct OMO sales (operation market operation to

sell government bonds) to manage excess liquidity, bond yields have moved up more than 15 basis points.

Given the RBI’s objective of liquidity management, we expect the timing and quantum of the OMO sale

auctions would be dependent on the prevailing liquidity condition in the banking system.

The banking system liquidity (as measured by banks’ net lending/borrowing in the RBI’s liquidity

adjustment facility) is currently in a slight deficit of Rs. 29 billion. While government has a surplus cash

balance of Rs. 2.86 trillion which will eventually add to banking system liquidity upon government

spending.

Chart – III: Banking System Liquidity is near neutral as the government continue to maintain high surplus

balances

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

Core Liquidity"Banking System Liquidity"

Source – RBI, Quantum Research, Data as of October 6, 2023

Debt Market Observer

Quantum Fixed Income October 2023

#Core Liquidity = Banking system Liquidity + Government cash balance+ excess bank reserves

We expect OMO sale auctions will be conducted only when the banking system liquidity is in surplus. For

total quantum of the OMO sale, we expect the RBI will also consider other natural drainers of liquidity like

currency in circulation.

Currency in circulation tends to increase during the second half of the financial year between October to

March due to high cash withdrawals from banks during festive and wedding season. Upcoming state and

union election might also lead to an increased cash withdrawals this year. Based on the historical trend, we

expect a durable liquidity outflow of around Rs. 2.0-2.5 trillion till March 2024. This can take out almost

entire durable liquidity surplus (Banking system liquidity + Government cash balance) over the next five

months. Thus, we expect the total quantum of OMO sale to be limited to Rs. 400-500 billion only.

Chart – IV: Increased Cash withdrawals to tighten liquidity condition between October-March

FY20FY21FY22FY23

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Change in Currency in Circulation During Fiscal Second Half

Source – RBI, Quantum Research, Data as of September 29, 2023

Banking system liquidity will likely ease in November due month end spending and large government bond

maturities to the tune of Rs. 1.43 trillion. The RBI may conduct OMO sale auctions during November to

absorb the access liquidity.

Based on the RBI’s bond holdings, we expect OMO sales to be concentrated in the shorter maturity bonds

particularly those maturing between years 2025 to 2029. Thus, we might see yield curve moving higher in

the intermediate maturities while long term bond yields may remain anchored drawing comfort from

low overall quantum of OMO sales.

Debt Market Observer

Quantum Fixed Income October 2023

Market Outlook

Given the sharp jump in bond yields since start of the month, much of the near-term negatives are

already priced for. The risk of geopolitical conflict intensifying – pushing commodity prices higher,

will continue to keep investors on sidelines in near term.

While from a medium-term perspective, outlook for bonds looks favourable supported by

peaked policy rates, strong external position, and favourable demand supply mix. Falling core

inflation should also be supportive for bonds as near-term risks subside.

At current yield levels, valuation also look reasonable for medium to long duration bonds. The 10-year

government bond is currently trading at 85 basis points above the policy repo rate. Given the policy

repo rate is near cycle peak, this spread looks significantly higher than its historical average during

peak rate environment.

In line with this view, we would use every rise in yield to extend the portfolio duration by

accumulating long term bonds in a staggered manner.

What should Investors do?

With most of the government bond yield curve above 7.30%, there is decent accrual available at

current levels. There is also a strong case for yields to decline over the next 1-2 years based on the

reasons described above.

Investors with 2-3 years holding period can consider Dynamic bond funds which have flexibility to

change the portfolio positioning as per the evolving market conditions.

Investors with shorter investment horizons and low-risk appetites should stick with liquid funds.

Portfolio Positioning

Scheme Name Strategy

Quantum Liquid Fund The scheme invests in debt securities of up to 91 days of maturity

issued by the government and selected public sector companies.

Quantum Dynamic

Bond Fund

The scheme to invest in debt securities issued by the government

and selected public sector companies.

The scheme follows an active duration management strategy and

increases/decreases the portfolio duration (sensitivity to interest

rates changes) in accordance with the Interest Rate Outlook.

Given sharp jump in yields, we have increased the portfolio duration

of the fund in line with our positive medium-term outlook. We

intend to keep portfolio duration high to benefit from potential fall

in yields as per our view.

Debt Market Observer

Quantum Fixed Income October 2023

Disclaimer, Statutory Details & Risk Factors:

The views expressed here in this article / video are for general information and reading purpose only and do not constitute any

guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund

is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not

meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of

any financial product or instrument 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. 

Risk Factors: Mutual Fund investments are subject to market risks, read all scheme