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Below are Views On Fixed Income Monthly Commentary – September 2021 by Pankaj Pathak, Quantum Mutual Fund

August was a positive month for the bond market. Bonds yields came down across the maturity curve. The only exception was the 10-year bond, on which yield moved up marginally from 6.20% on July 30, 2021, to 6.22% on August 31, 2021.

On the yield curve, the 2-4 year maturity bonds rallied the most as yields in this segment fell by about 20 basis points in the month. The longer maturity bonds (above 10-year maturity) also participated in the rally with a 7-15 basis points drop in their yields; in the month. The rally was first triggered by a substantial increase in liquidity in the banking system which supported a significant decline in the short-term bond yields. Subsequently, a sharp fall in crude oil prices, dovish MPC minutes, and a non-event ‘taper’ talk in the US revived the market sentiment.

The RBI continued its support to the market. It conducted two OMO purchase auctions of Rs. 250 billion each under the GSAP 2.0 and tactically intervened in primary auctions to keep yields under check.

CPI inflation softened to 5.6% in July 2021 as against 6.3% in the previous month. Although a big part of the decline is due to the base effect, underlying inflationary momentum has tapered down. Nevertheless, the headline CPI inflation is expected to average between 5.5%-6.0% in FY22 as against the RBI’s target of 4%.

It could prompt the RBI to start policy normalisation as uncertainty around growth subsides. The RBI is already in the process of normalising its liquidity operations by increasing the size of variable-rate term reverse repos (VRRR). Moving forward, it may introduce longer tenor VRRRs to absorb part of the liquidity surplus for a longer period and push up the overnight rates closer to the reverse repo.

We would also expect a staggering increase in the reverse repo rate from 3.35% to 3.75% possibly starting from the December policy meeting. Change in policy stance from “Accommodative” to “Neutral” and hike in repo rates may start in the first half of next fiscal year.

In the near term, market will take cues from the developments in the money markets and RBI’s response to it. The core liquidity surplus has increased to over Rs. 11 trillion now as against ~Rs. 7 trillion at start of the current fiscal. The 3-month Treasury bill rate which was at ~3.45% a month back is currently around 3.28%.

This amount of excess liquidity could limit RBI’s capacity to buy bonds and foreign exchange. If forex inflows continue, the RBI will have to deploy other tools like MSS bonds (Market Stabilisation Scheme), SDF (standing deposit facility), etc., to absorb part of excess liquidity on a durable basis.

This is a significant risk for short-end bonds which are richly priced at current levels. On the other hand, the long end of the yield curve still offers a reasonable valuation considering the terminal repo rate may remain below its pre-pandemic normal.

Another positive for long-end bonds is the government’s fiscal position. The central government tax collections have been significantly higher than budget estimates during April-July 2021. If the trend sustains, there is a possibility of a significant reduction in the government’s borrowing program. Long-term bonds would gain more in case of borrowing cut.

There is still very high uncertainty around the future trajectory of interest rates. The biggest risk for bonds would be a change in the RBI’s view on inflation being ‘transitory’. There is also a threat of faster normalisation of monetary policy in developed economies which could cause turbulence in emerging countries like India.

Thus, for long-term asset allocation in fixed income space, investors should go with dynamic bond funds over longer duration funds. The dynamic bond fund gives flexibility to the fund manager to change the portfolio positioning depending on the evolving market condition.

However, for any such allocation, investors should be prepared to hold for a longer time horizon while also tolerate some volatility in the intermittent period. Conservative investors should stick to categories like liquid funds that invest in very short maturity debt instruments and tends to benefit from rising interest rates. We also suggest investors lower their return expectation from debt funds as the potential for capital gains will be limited going forward.

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