Indian Government Sovereign Paper - the Search for Carry Ends Here

The Indian fixed income market got the much needed respite in the month of March, after the challenging first 2 months of 2016. The 10 year bench mark (10Y Govt. of India bond) yield which touched a high of 7.88% is now trading in 7.50-7.60% range. The two key positives which turned the tide in favor of bond bulls has been the adherence to fiscal discipline and the inflation situation, which the Reserve Bank of India (RBI; India’s central bank) will keenly watch in setting the policy rates going forward. Both have now turned favorable for the RBI to effect further monetary easing. Additionally, the on-going open market operations (OMO1) purchases by RBI amidst tight liquidity situation and the absence of primary supply of sovereign paper has supported bond prices to a large extent.

In the Union budget (link to my commentary -, the Indian government opted for macro stability over growth. Prior to the Budget there was considerable uncertainty about the intent of the Government to pursue the fiscal roadmap, and now with a 3.5% fiscal deficit target for FY17, one major hurdle for monetary easing has been passed. The fiscal assumptions in the Union Budget for 2016-17 are largely credible, though one may argue that, there are several risks to the fiscal deficit estimate in FY17 in terms of inadequate bank recapitalization provision and lower revenues from asset sales (telecom spectrum, disinvestment, strategic stake sale). However, I still expect the government to adhere to this target irrespective of potential challenges, given its past track record.

Another key positive for the fixed income market has been inflation. The last reading of headline retail inflation for Feb-2016 at 5.20% was significantly lower than market expectation even as the core (inflation excluding food and fuel) moved up. On the growth side, India’s nominal GDP growth has to pick up which I believe will happen but with a lag. I believe that lower than expected CPI inflation together with the desired fiscal rectitude shown by the Government has cleared most of the hurdles for a 25 bps cut in benchmark repo rate to 6.5% in RBI’s April policy meet. The latest cut in various small savings2 rates, which were out of tune with the current market, by 40-120 bps in line with the falling bond yields and inflation is also a step in removing impediments for transmission of monetary policy via interest rates. Beyond April, if the monsoon is normal and the inflation situation remains stable, another 25 bps rate cut in the second half cannot be ruled out, which I believe will be the last rate cut in the ongoing easing cycle; in 2015, RBI cut policy rates by 125bps beginning January 2015.

Considering that RBI is gradually approaching the end of its rate cutting cycle, there is limited downside scope for bond yields, as the market will now focus on the demand-supply dynamics. No doubt Govt. of India’s gross and net borrowing number of Rs.6 trillion and 4.25 trillion is below market expectations.

However, one should keep in mind the increasing trend in state government borrowings through State Development Loans (SDLs3) which has been rising on an average 20% in the past couple of years. I expect the supply of SDLs to increase to Rs.3.2tn in FY17 (Rs.3.0tn in FY16), which is over 50% of gross central government borrowing and over 70% at net level. With their additional yield kicker of 50-75 bps, increased supply of SDLs is likely to reduce the appetite for Govt. Security (G-sec; sovereign paper), thereby adding pressure on overall yields. Nevertheless, I believe that the current spreads on SDLs adequately discounts these concerns and investor can look at this segment for yield pickup. On the corporate space, AAA corporate bonds spreads, at 3-5 year segment at around 60 bps appear reasonable considering the historical average of around 50 bps and our expectation of steepening trend in the yield curve. The 10 year corporate bond yields are trading at a spread of around 70 bps - higher than the historical average of 50bps primarily due to rise in SDL bond yields.

Given the government’s preference for issuing longer dated bonds I expect average maturity of government debt to lengthen and as a result, supply at the shorter end of the curve will remain limited. I expect the 10 year benchmark yield to consolidate in the range of 7.4%-7.5% in FY 17. However, I continue to believe that the yields curve will steepen. Risks to my view would be more than expected credit growth (11-12%) which would then make RBI’s OMO very critical. Additionally, there are $30bn of FCNR4 deposits maturing in September this year which has the potential to upset liquidity calculations.

I believe that the search for carry ends with the Indian government sovereign bonds. There are reasons to believe so. Investors need to look at the INR through a fresh pair of lens. Last year, in a major monetary policy overhaul, RBI adopted inflation targeting as a guide to its monetary policy for the first time. India is among the few EM countries in the world with inflation targeting as a monetary policy tool. Inflation targeting will mean that the INR’s depreciation will not be as severe as in the past which will leave more carry in the hands of the investors. The INR has depreciated 6-8% every year against the USD in the past but post Raghuram Rajan joining RBI as the RBI governor in September 2015, the currency has actually appreciated by 3% against the dollar. On the other hand, with amongst the lowest foreign currency debt, India’s fiscal indicators look resilient to weather global volatility. RBI is warming up to relook foreign investor ownership in India’s sovereign debt which has historically remained low (4% of outstanding sovereign debt). RBI has already started relaxing curbs on foreign ownership in Indian sovereign debt; in September 2015, the RBI announced hike in foreign ownership in Indian sovereign paper to 5% in phases. There are reasons to believe that additional limits will be opened up albeit in a gradual way as macro indicators stabilize both at home and global. With fiscal rectitude, all time high forex reserve stock, stable currency, and relatively stable macro I believe that the search for carry ends here.

Disclaimer: The views expressed are of Tata Asset Management Ltd. and are in no way trying to predict the markets or to time them. The views expressed are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Asset Management will not be liable in any manner for the consequences of such action taken by you. Please consult your Financial/Investment Adviser before investing. The views expressed may not reflect in the scheme portfolios of Tata Mutual Fund.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.

1 OMOs are the market operations conducted by the RBI by way of sale/ purchase of G-sec to/ from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing liquidity into the market.

2 Small savings are deposit schemes offered by the government to provide a risk free option to households. In March 2016, the government reduced interest rates across various small savings schemes by 40-130bp, effective from 1 April 2016. The reduction in rates has been particularly steep for shorter-tenor instruments (~100-130bp). Additionally, interest rates will be reset every quarter based on the average month-end G-sec rates of the preceding three months

3 SDLs are market borrowings by state governments. RBI co-ordinates the actual process of selling these securities. Each state is allowed to issue securities up to a certain limit each year. DLs are, however, considered safer than loans by state government undertakings because RBI has the power to make repayments out of central government allocation to states which lie in an account with RBI

4 FCNR deposits stands for Foreign Currency Non-Repatriable account deposits. This is a Fixed Deposit Foreign Currency account and not a savings account. Deposits in this account can be made in any of the major currencies like US Dollar, UK Pound, Canadian Dollar, Deutsche Mark, Japanese Yen and Euro.

© Tata Asset Management

Read more commentaries by Tata Asset Management