Beware the ire of bond vigilantes

In mid-November 2017, when the ratings agency Moody’s upgraded India’s credit rating from Baa3 to Baa2 after a 13-year gap, most expected Indian bond market investors to rejoice, and drive down yields. Yet, owing to a number of unfavourable domestic developments, Indian bond markets have actually under-performed most emerging market peers since that upgrade, with yields on the benchmark 10-year government bonds rising by 26 basis points. A basis point is one-hundredth of a percentage point. A rise in yields reflects a fall in bond prices, and signifies losses for bond-holders.

In fact, the spread between the 10-year government bond yield and the central bank’s policy rate is close to highs last witnessed during the taper tantrum of 2013, when bond-market led outflows resulted in a sharp spike in domestic yields, and contributed to a crash in the rupee market. The rise in the spread reflects growing fears of higher-than-anticipated government borrowing. The higher fiscal deficit and rising global commodity prices may stoke the fires of inflation, prompting the central bank to raise policy rates in coming months, bond markets fear.

The concerns over fiscal slippage, i.e. the Union government missing its budget deficit targets, intensified after the government announced additional borrowing of Rs50,000 crore for the year ending 31 March 2018. The April-to-November 2017 fiscal deficit has already overshot the full-year’s target by 12%. This is due to markedly higher expenditure in the April-to-November period compared to the historical trend, and the lack of commensurate increase in revenues.

The increase in government spending has been driven by higher revenue spending, suggesting that this could be inflationary. It is this fear coupled with a demand-supply mismatch in the bond market that has driven up bond yields. The demand for bonds has declined largely on account of wary bankers, who are unwilling to absorb greater mark-to-market losses on their bond holdings at a time when yields are rising.

The only silver lining is that foreign investors have as yet refrained from selling, perhaps in anticipation of rupee appreciation, which could offset the fall in bond prices. While increasing the FII debt limit might lead to inflows and support the bond market in the short term, this is fraught with risks. Raising these limits will also raise the risk of sudden outflows if domestic or global conditions worsen. Such risks will rise as the government’s borrowing increases, and other inflationary risks such as crude oil prices increase.

While the bond markets seem to be pricing in these risks, stock markets seem to be oblivious to them, leading to a growing divergence between the two.

The bond-equity divergence has not gone unnoticed. In a recent letter to employees of Kotak group, the managing director of Kotak Mahindra Bank Ltd, Uday Kotak urged them to be cautious about investing in the stock markets, Mint reported last week.

“I would advise investors to exercise caution as stock prices are moving up. Organised savings are chasing limited supply of stocks,” Kotak said in the letter. “Keeping aside the valuations and earnings argument, the factor that worries me is debt instruments are being perceived as high risk (in view of hardening of interest rates and the resulting erosion in value of the instrument) and that investors are shifting from debt to equity which is being perceived safer in comparison,” wrote Kotak.

Kotak’s warning is primarily for domestic retail investors who have been increasing their portfolio of stocks (and not bonds), helping sustain the equity market rally. Bond markets on the other hand are driven by institutional investors, who also tend to be hyper-sensitive to the threat of rising fiscal deficit and inflation.

While it is the stock market movements that garner more attention, let us not forget that it was heavy selling in the bond markets that precipitated the taper tantrum of 2013. The Indian economy has come a long way since then, but risks to macro-economic stability are rising.

Finance minister Arun Jaitley should remember India’s recent financial history, and avoid risking the wrath of the bond markets when he presents the Union budget next month.