With the limelight being hogged by the turbulence in the equity markets, most analysts seem to ignore what is happening in the domestic debt markets despite the upheaval in the global debt markets.
This despite the fact that in the current fiscal, unlike ever before, total debt trade and transactions have outpaced the trade in domestic equities by a long way. Foreign institutional investors shopping in government securities in the current fiscal so far have exceeded last year’s full figures by more than five times.
From another perspective, the simple fact that bond yields today are a good 75 basis points (bps) lower than what these were before the Reserve Bank of India (RBI) increased the policy rates in the credit policy in April, should draw more granular attention to the movements in the bond markets.
There are three signals that can be picked up from the bond markets.
First is that the yield on 10-year government security at 7.50% is lower than the yield on the six-year paper which is trading at a higher yield of 7.70%; a good 20 bps over the newly introduced 10-year benchmark paper. Normally, it is expected that the yield curve will be one in which longer maturity bonds have a higher yield compared with shorter-term bonds due to the risks associated with time.
It is tempting to take a trader’s view and look at this as an aberration that is being caused by higher trading volumes in the 10-year benchmark paper and its limited supply in the secondary market compared with the lower traded volumes in the six-year paper and its higher supply in the secondary market.
But in the extant macroeconomic environment, this unusual pattern is indicative of a larger macroeconomic story of interest rate changes, efficacy of the transmission of policy interest rates in the system and, of course, about the economic outlook.
This is not to say that what is being observed in the debt market today is an inverted yield curve wherein the shorter-term yields are higher than the longer-term yields, and predict a continuance of which can be a recession in the economy.
Instead, the situation is closer to being a flat or humped yield curve in which one the shorter- and longer-term yields are very close to each other, which is a predictor of an uncertain economic transition.
Second is about how this convergence in the yields of short and long maturities has come about. Is it that the yield-rate environment has been such that the short-term interest rates have been increasing at a faster rate than long-term interest rates and it is this that has caused the yield curve to flatten. Or is it that the long-term yields are decreasing faster than the short term. The implications are vastly different. In the former, it is indicative of a continuance of slowdown over a longer phase. On the contrary, the latter indicates a greater confidence in the long term.
In the present context, a bear flattener situation has also occurred with government raising the key short-term policy rates which drove up the short-term bond prices down, increasing their yields rapidly relative to long-term securities.
Third is the quality spread in across bonds that is, the additional yield an investor receives for acquiring a corporate bond instead of a similar government instrument. The prices of corporate securities are invariably lower giving them a higher yield. Traditionally, the spread in the markets has been 100-150 bps.
What can be observed is that this spread between corporate bonds and government paper has been narrowing over the last few months. This is also a bit of anomaly as in the current inflationary situation, the credit spread between corporate and government securities ought to have widened. This is simply because investors must be offered additional compensation in the form of a higher coupon rate for acquiring the higher risk associated with corporate bonds. Yet, exactly the opposite seems to be happening.
Over and above these factors, investor sentiment also drives corporate bond yield spreads. Typically, the bond spreads vary in tandem with investor sentiments. As such, when business confidence is low, bonds get underpriced. Consequently, in this phase, yield spreads are likely to converge. Within the different types of bonds, high-yield bonds demonstrate greater susceptibility to under pricings because of sentiment. The spread between high-yield and low-yield bonds, therefore, shows greater convergence as is the case now.
The message that the bond markets seem to be sending is that too much should not be made of the growth in the real economy as indicated by recent data on gross domestic product and the Index of Industrial Production. The financial sector is not on the same wavelength. The disconnect between the real and financial side of the economy is a cause for concern. The former is more likely than not to mirror the latter, rather than the other way round.
Haseeb A. Drabu is the chairman and chief executive of Jammu and Kashmir Bank. The views are his own and don’t necessarily reflect the views of the organization he works for. Comment at email@example.com