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Photo: Hindustan Times
Photo: Hindustan Times

Indian bonds: Go for a ‘weak long’

As RBI approaches the end of its rate cutting cycle, bond yields are likely to drift lower, but the downside room is rather limited

The Indian bond market has certainly been appreciative of the Union budget for the fiscal year 2016-17 (FY17). After remaining stubbornly high, close to where they were a year ago, bond yields are finally showing signs of correction, with the benchmark 10-year yield recording a six-month low last week. This is because the government has stuck to its commitment by ensuring that the fiscal deficit target for FY17 remains at 3.5%. More importantly, the net borrowing announcement for FY17, at 4.3 trillion, has been somewhat less than market expectations ( 4.8 trillion), ushering a fresh view about demand-supply dynamics of the next year.

Those who now stand extremely bullish are ignoring the fact that in FY17, state budgets will play a more important role for bond yields than the recent Union budget. Seemingly, while the net supply of Indian government bonds (IGBs) will go down by 3.5%, that of SDLs (State Development Loans) could rise by around 20%. Thus, the overall market borrowing (G-Secs plus SDLs) shall still rise by 4.9% in FY17 (HDFC estimate).

Meanwhile, the commercial banking sector, the biggest buyer of IGBs with 45% share, is unlikely to offer robust demand support in FY17, owing to low deposit growth, and consequently, a muted requirement of the SLR-linked G-Secs. Besides, the foreign appetite for Indian debt could remain lacklustre on account of global growth uncertainties and rupee depreciation.

There is also a belief that once the euphoria related to the budget announcements fade away, the focus of the market shall shift back to concerns and uncertainties related to the UDAY scheme (Ujwal Discom Assurance Yojana). The fear is that if all the states agree to its implementation, 2.1 trillion worth of bond supply could hit the investment book by the end of FY16 and another 1.1 trillion by end of FY17.

In my view, there seems to be some lack of clarity in the markets and the fear of UDAY supply seems to be overstated. Effectively, instead of coming to the market, it is likely that there would be a one-to-one swap between discom loans currently held by the banks and UDAY bonds issued by the states. Thus, the asset-mix of the banks would just change from credit to investments, with no immediate impact on the market yields.

Although such a swap could depress net interest margins (NIM) of the banks, as coupon on the state government bond is likely to be lower than the originally contracted lending rate, banks would still be willing to consider the swap option. This is because direct exposure to state governments would attract 0% risk-weight, compared to 20% for state government guaranteed exposure to power distribution companies, thus freeing up substantial amount of risk-weighted capital for banks. Moreover, incentives such as the ability to hold to maturity could be offered, obviating the need for marking to market, and thus making UDAY bonds all the more attractive for banks.

Even if a fraction of bonds come to the market, the Reserve Bank of India (RBI) has indicated that they could be privately placed. Moreover, the supply burden could be more controlled than initially envisaged. As of now, only seven states—Bihar, Jharkhand, Gujarat, Chhattisgarh, Rajasthan, Uttar Pradesh and Punjab—have signed the MoUs, with the expected bonds flow of 80,300 crore in FY16 and 40,100 crore in FY17.

No doubt that as more states come on board, the amount of debt issued could go up. However, there is an option to transfer the grant over three years, and that means part of the burden could be staggered to FY18.

Thus, putting it all together, extreme prospects for the bond yields are a bit exaggerated in my view. Bearishness on account of UDAY bond supply is unwarranted. Similarly, amid fiscal consolidation, although there is scope for further monetary easing, it is probably not large enough to warrant a very big decline in sovereign bond yields.

As RBI approaches the end of its rate cutting cycle, bond yields are likely to drift lower, but the downside room is rather limited.

Tushar Arora is a senior economist at HDFC Bank. The views expressed are personal.

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