The Indian bond market rally has stalled lately, with the actively traded 10 year retracing around 30 – 35 basis points from the recent lows in this cycle. After the dramatic rally between May and July, some sort of a consolidation / retracement was probably to be expected. Indeed while expressing our continued constructive view, we had warned of such an eventuality in a July note (https://www.idfcmf.com/insights/too-much-a-bond-and-macro-update/) . The proximate cause for this retracement, apart from traditional profit booking pressures from banks, is an escalation of fiscal worries, despite an extra ‘windfall’ of INR 58,000 crores from the Jalan committee recommendations on RBI surplus transfer (https://www.idfcmf.com/insights/rbi-transfer-to-government-the-good-the-bad/). The worries on fiscal in turn are on 2 counts: One, while the government has so far shown admirable restraint, the chatter around an incremental stimulus refuses to die. Two, there is a fear that even without an explicit stimulus, the ongoing substantial revenue shortfall versus budget numbers may entail an involuntary fiscal expansion and hence extra bond supply to the market. The global bond rally has also recently stalled thereby removing one additional bullish impetus to local bonds though, it must be said, our markets had largely ignored the last leg of drop in global yields.
The fears around local fiscal are legitimate and indeed pose the one dominant risk to bond yields. This is especially since, as has been argued extensively before, the combined public sector borrowing today is already exhausting all of local household financial savings and another 2% of GDP plus of offshore savings. Thus the appetite to absorb additional fiscal expansion is quite limited. Hence the debate is not whether we need a fiscal stimulus (counter-cyclical policy response is desirable is a truism and hence cannot be debated) but whether the unintended consequences of such an exercise (in the form of further crowding out and pressure on bond yields) can more than fully neutralize the positive effect of such a stimulus. This is a point that is also presumably not lost on policy makers as well.
While fiscal remains a black-box and the key risk to bond markets, the following perspectives need to be kept in mind:
1. Although risks abound on the revenue side, it is also true that there is substantial scope for compression on the expenditure side. Expenditure through budget is scheduled to rise by 20.5% versus actuals of the previous year. There can be material savings here without a material compromise on actual spending as some subsidy financing etc can go back ‘below the line’. Given that realized expenditure growth in the previous financial year was only 7.9%, there is enough room here to still grow the rate of spending year on year and yet save on the fiscal. As an example if spending were to grow at 14% (still much higher than the previous year), there will be a ‘saving’ of approximately INR 1,50,000 crores versus the budget numbers. Critics will fret the quality of the budget, but this is a constant from the previous year.
2. We have argued before that RBI needs to probably step up money creation (https://www.idfcmf.com/insights/money-creation-to-pick-up-pace-an-rbi-update/). While the excess transfer mitigates this to some extent, we still see room for open market operations (OMOs) for the rest of the year. This is especially true if monetary policy indeed has to mount the bulk of counter-cyclical response and if policy now is conclusively focused on ‘market based’ transmission of interest rates into lending rates.
Bonds are cheap
Traditionally, in this part of the cycle the 10 year government bond should be trading close to the repo rate. The 125 odd term spread (10 year to repo rate) today is largely owing to bloated general government borrowings in relation to the risk capital going around to support it. Nevertheless, given that there is more monetary easing in the pipeline and that RBI may yet be buying more bonds, we think bonds are quite attractive from this standpoint.
The other more macro perspective that determines just how attractive bonds are, is summarized below:
India’s nominal GDP now looks like to be in the 8 – 9% handle for the foreseeable near future. This is a proxy for the revenues for an average economic agent. Assuming a nominal credit spread of 200 – 300 bps (which doesn’t even probably factor in the current dislocation), leverage inherently becomes unsustainable at such nominal growth rates versus the realized cost of borrowings. Indeed, the bars in the chart suggest there have been very few instances of this differential being so low as it is today. The fact that most of these ‘low bars’ pertain to the last few years is also testimony to the macro implications of higher real yields over a sustained period of time.
Conclusion
The dominant risk remains that from fiscal in the Indian bond market story. However, for now the working assumption is that, for the reasons described above, the net impact on market supply of bonds from this may not be as bad as may be feared currently in some quarters. So long as this assumption holds, quality bonds are looking quite attractive / cheap on a variety of parameters including on spread versus repo, on a real yield basis, as well as versus current and expected nominal GDP growth rates.
On our part we have used the recent rise in yields to increase exposure into the 10 to 14 year segment in our active duration products, from the overweight 6 – 9 year stance we had before. This will remain an active decision basis the evolving environment.
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