Indian Debt Markets: Explained by ICICI Securities

Indian debt markets, in the last two years, witnessed a good rally with most funds having clean portfolios with no credit risk event delivering annualised returns in the range of 11-12%. Funds with higher duration delivered even higher returns as long bond yields, particularly G-Sec yields, delivered higher capital gains as yields decline on a consistent rate cut by the Reserve Bank of India.

While the RBI in its last few policy meetings kept benchmark rates on hold, their liquidity stance remains accommodative. RBI announced the following measures like increasing the quantum of liquidity infusion into the market, via special open market operations (OMOs) and outright bond purchases, announcing Rs 1 trillion of on-tap TLTROs, conducting OMOs in state developments bonds (SDLs) as a special case during the current financial year.

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In the minutes of the last Monetary Policy Committee meeting, committee members reiterated their assessment that the increased CPI was mostly due to supply side constraints. While members expressed the need to closely observe any signs of generalization of these supply-side shocks and prevent spillovers, the majority of the members were consistent in their view that inflation would be on a downward trend, going forward.

The MPC acknowledged the need for a counter-cyclical fiscal policy in this situation and need to reduce the long term bond yields. CPI Inflation declined sharply and was below market expectation at 4.59% in December compared to the November print of 6.93% on the back of a sharp reversal in food prices coupled with favourable base effects. The reading is now down significantly in the last two months with a series high print of 7.61% in October indicating the inflation print peaked in October. It is likely to provide the much needed data comfort for MPC to continue its growth supportive stance.

Outlook:

The Union Budget is likely to be an important event being watched by the bond market. Fiscal deficit for the current year is likely to be much higher at 7% given muted tax collection, low disinvestments and higher spend towards food & cash distribution programmes initiated by the government during the pandemic. Given the need for higher infra spend to shore-up the economy, ICICI Securities built in a 5% fiscal deficit for FY22E as well. This may put pressure on yields with higher G-Sec supply.

RBI recently indicated at moving towards normalising the current excess liquidity. The same, however, may not materially impact the yields curve, except at very short-term, which was trading at abnormally low levels. Banking system liquidity is likely to remain in surplus over the next few quarters. Long term yields, however, may remain under pressure given already low levels and higher supply for the next financial year. The resumption of foreign inflows will be key in supporting the longer tenure yields along with RBI purchases.

The yield for quality bond portfolios like corporate bond funds is trading at cyclical lows. Therefore, the return expectation should be lowered. Selective funds in the medium term category offering higher yield with measured exposure to sub-AAA rated papers are better placed for long term debt allocation. However, it is better to avoid lump sum allocation and adopt a more staggered approach over the next few months