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Power Point
Why investors must have higher debt allocation over the next 12-18 months
- Resultant impact of easy fiscal and monetary policies over the last 3-5 years has led to strong growth and inflation spiral
India bond markets have witnessed quite a bit of volatility in the last few months. The yields on the 10-year government bonds fell from 7.45% to 7% and have risen back to 7.25-7.35% due to rise in US bond yields and crude prices
There is enough reason to believe that the market dynamics are changing from three facets:
Fundamental—Macro picture highlighting the case for adding bonds.
Structural—Changing market demand-supply dynamics and a case for long bonds (duration).
Relative—Perspective from history highlighting outperformance of bonds markets over other asset classes.
Fundamental theme
Inflation: Headline inflation is at ~5%. Decline in core inflation continues and this could be likely go below 5% as slowing growth in China and the weak global economy will likely keep commodity prices muted.
Growth: India’s GDP growth seems to be peaking off and could remain subdued at sub 6% levels over the next two years. This is due to the fall in fiscal impetus, and weakness in global economies.
Favourable external position: India’s external position remains comfortable considering the trinity (Forex reserves, balance of payments and current account deficit). Is China’s loss India’s gain? – Perhaps yes!
Narrowing US-India interest rate differential: To combat the pandemic, the US government increased spending to unprecedented levels leading to wider fiscal deficits (from sub 3% to 8-10%), a significant expansion of the US Fed balance sheet from $1-2 trillion and an easy monetary policy stance for 2.5 years.
Resultant impact of easy fiscal and monetary policies over the last 3-5 years has led to strong growth and inflation spiral. In the last 12 months, the US Federal Reserve hiked interest rates to the tune of 500 basis points, or bps, and shrank US Fed balance sheet from $3 trillion to $1 trillion. One bps is one-hundredth of a percentage point.
The narrowing interest rate differential has kept the Reserve Bank of India (RBI) on tenterhooks. However, unless we see a large depreciation on the rupee or higher outflows, we do not expect RBI to raise interest rates. RBI has already engineered a 25bps rate increase in the last two months through tight liquidity conditions.
Therefore, bond markets are pricing in most of the negatives, macro theme augurs well, and fundamentally, the rates cycle looks positive.
Structural theme
A question that arises for bonds is high fiscal deficits and large government bond supply, which, in turn, raises concerns on bond yields. If we analyse the trend over last 5 years, we have generally witnessed a structural demand-supply gap of ₹50,000 to ₹1.5 trillion every year, where supply was higher than demand, which in turn is met by open market operations (OMO) purchases by RBI.
Nonetheless, in the last few years, there has been a growing trend of a significant increase in assets under management/flows with real money investors from ₹55 trillion to ₹85 trillion. This has been helping to fill in the massive demand supply gap despite huge government borrowing plans over the last few years.
In addition, we expect the fiscal deficit to normalise over the next 3 years from 6% to 4.5% and hence don’t expect a significant jump in borrowing numbers. Also, with India Sovereign bonds being included in JP Morgan Global indices. we expect $25 billion of flows in next 12-18 months which would be highly favourable for demand-supply dynamics for bonds.
Relative theme
While bonds are always looked upon as an asset class that provides stability over a longer period, surprisingly and contrary to opinions, debt has outperformed other asset classes over the period’s extreme/long interest rate hikes and tight financial conditions.
To conclude, after analysing the fundamental, structural and relative themes, we advise a higher allocation for debt for next 12-18 months. A few macro risks that stand out are rising crude oil prices, China’s recovery and a possibility of China devaluing its own currency to attract flows.
Devang Shah is co-head, fixed income, Axis Mutual Fund.
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Business NewsMoneyWhy investors must have higher debt allocation over the next 12-18 months
First Published:5 Dec 2023, 09:52 PM IST
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