An Environment Recap
The bond market has been lately juggling relatively strong triggers pushing and pulling on either side. On the positives, the government’s fiscal position has improved substantially, foreign portfolio investors (FPIs) seem to have been coming back over August and September (alongside chatter of bond index inclusion), and a recent welcome fall in food prices may lead CPI for the September quarter to print significantly below RBI’s latest forecast. On the flipside, oil is on a boil, US yields have risen post the latest FOMC meet, and domestically RBI seems reluctant to let core system liquidity rise further (with obvious implications for its bond buying program). The global negatives seem to have won the last few days thereby leading to some recent rise in yields.
Of the negatives mentioned above, the biggest wildcard is obviously oil prices. However, from a macro perspective we are in a relatively strong position currently to absorb this rise. The biggest buffer is a robust external account and forex reserves which will make the rupee relatively resilient to this rise in oil. Correspondingly, the pass through to inflation via the weaker currency route will likely be shallower. Additionally from a monetary policy standpoint, the general demand destruction impact of higher crude will be more significant given the weaker level of aggregate demand in the system and the already elevated starting levels of crude prices. Finally, at least for the near term, inflation prints have some cushion to absorb higher prices. That said, one has to watch for crude as the number one emerging risk. The other one about higher US yields can be easily lived with for now, and is unlikely to have much more than a sentimental effect given the external account benefits currently in play for India as described above.
The Borrowing Calendar
We have detailed our current bond market framework in a recent note (https://idfcmf.com/article/5730). To recap the conclusion there, in our view the upcoming flattening of the curve on RBI normalization will for the most part play out between 1 and 5 years (and various combinations of tenors within this overall segment) while longer durations (10 and 15 years) are unlikely to flatten much more relatively given the multi-year bond demand-supply issues that we are likely in the midst of. This is despite a view of gentle fiscal consolidation (gross bond supply will still be quite large given large bond maturities over the next few years) and likelihood of global bond index inclusions (FPIs will likely replace RBI has the ‘residual buyer’).
The central government’s borrowing calendar for the second half of the financial year announced yesterday will likely also provide near term support to this view. Thus the government has decided to subsume the back-to-back GST related borrowing within its own calendar for the second half as well (thereby de-facto borrowing lesser for its own requirements, reflecting its strengthened fiscal position). Furthermore, the bulk of the supply reduction is in the 5 year segment. Details of the calendar are given below:
The following observations are noteworthy from the table:
- Absolute amount of borrowing is lesser in all segments (reflecting lower gross borrowing in second half) except for the 10 year segment. However, the fall in borrowing is substantial for the 2 year and 5 year segments (less than 50% of first half).
- The percentage borrowing of the calendar has fallen off sharply in the 2 and 5 year segments but has risen substantially for the 10 year segment. It’s marginally lower for the 14 year, similar for longer end, and slightly higher for floating rate bonds.
Apart from the higher duration supply embedded in the central government calendar, we would expect state development loan (SDL) supply to also start to pick up now (consistent with the usual trend of back-ended borrowing for states). Furthermore, we are also seeing long end corporate bond supply now rising over the past few weeks. All of this implies a higher headwind for longer duration bonds and gives us greater confidence in our view that 5 to 10 to 15 year spreads are unlikely to fall meaningfully from here, and that the best play on the current steepness of the curve (and the best carry adjusted for duration value) is in the 5 year space.
Portfolio Strategy .
Consistent with the above view, we have been running overweight in the 5 year government bond segment across our actively managed bond funds. Elsewhere as well, we are playing for the 1 – 5 year compression (including tenor variations within this segment) to the extent provided for by the overall maturity framework for the particular fund. The government bond calendar will likely accelerate the progress towards the more medium term view on the shape of the curve that is embedded in our portfolio strategy.
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