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What does the bond market shakeout mean for investors?

What does the bond market shakeout mean for investors?

23 Jul 2021

The interest rate has the power to make or break an economy. The Reserve Bank of India, historically, had shied from accepting its interventions at the long end of the bond yield curve and often termed it as a mere liquidity operation. In the last two years, the RBI has not just intervened across the maturity curve, it has guided the market expectations through open commentaries about the level of bond yields. These actions have reduced volatility and induced an uneasy calm in the bond market.

However, the RBI-induced calm in the bond market has been broken in the past few weeks. Bond yields have moved up by 20-30 basis points in a matter of few days. The market witnessed a broad-based selling; – seen across the maturity curve. Even the 10-year benchmark government bond, which was held around 6%, broke out of its shell. As on July 13, 2021, the existing 10-year benchmark Gsec was trading at 6.20% and a new 10-year bond was issued at 6.1%.

This selloff could be attributed to – (1) a surprise jump in CPI inflation in the month of May 2021; and (2) rising crude oil prices.

The headline CPI had come at 6.3% against a market forecast of about 5.4%.

This one reading has reset the entire inflation trajectory and prompted a significant upward revision in the inflation estimate for the whole of FY22. Headline CPI inflation is now expected to average around 6.0% in FY22 as against earlier forecasts of around 5.1%. The RBI is yet to change its CPI inflation forecast to 5.1%. More importantly, it changed the market’s attitude towards inflation.

Chart – I: Inflation breached the 6% ‘Laxman Rekha’

quantum 1ET Online

Source – MOSPI, eaindustry.nic.in, Quantum Research; Data as of June 30, 2021

As a relief, sequential momentum softened across many components of the CPI basket in June 2021. The headline CPI came marginally lower at 6.26% in June. This was a positive surprise for the market as estimates were ranging between 6.6%-7.0%.

Rates poised to move higher

Given the extraordinarily large size of the government’s borrowing requirement, the RBI will have to continue its market interventions well into the future to maintain calm in financial markets. It is expected that the RBI will buy INR 4.0-4.5 trillion of central and state government bonds in FY22. This should extend some support to the market.

Chart – II: Government borrowing to remain high in foreseeable future

quantum 2ET Online

Source – CMIE, Indiabudget.gov.in, Quantum Research

However, we expect the RBI will continue to lower its other tactical market interventions like auction cancellations, devolvement, special OMOs, etc. and will allow market forces to adjust to economic reality.

Over the medium term, inflation and potential monetary policy normalization will play a more important role in shaping the interest rate trajectory. With gradual progress in covid vaccination and inflation picking up, talks of policy normalization will intensify.

We continue to believe that bond yields have already bottomed out in this cycle and expect it to move higher over the next 1-2 years.

What should investors do?
We have been saying this since the start of the year that investors should acknowledge that the best of the bond market rally is now behind us. At this time, it would be prudent to lower the return expectations from fixed income products– as money market yields, fixed deposits rates will remain low and potential capital gains from long bond funds will be muted.

Conservative investors should remain invested in categories like liquid funds where the impact of interest rate rise would be favorable. However, while selecting a liquid fund be cautious of the credit quality and liquidity of the underlying portfolio.

At this point where fixed deposit rates have come down to historical lows, liquid funds could be an option (with market risk) in comparison to locking in long-term fixed deposits. Liquid Funds invest in up to 91-day maturity debt securities, which get re-priced higher when interest rates rise. Fixed deposits interest rates remain fixed for the entire tenor thus lose out during a rising interest rate cycle.

Investors with a higher risk appetite and longer holding period can consider dynamic bond funds where the fund manager has the flexibility to change the portfolio when the market view changes. These funds are best suited for long-term fixed income allocation goals. However, do remember that bond funds are not fixed deposits, and their returns could be highly volatile and even negative in a short period.

(The author is a Fund Manager – fixed income, Qauntum AMC)