Analysis. Bonding with bonds

Although bond markets started off 2016 on a subdued note, the sharp drop in 10-year benchmark yield by around 113 bps (most of it came after currency replacement programme) led to softening of bond yields across the curve. Nevertheless, we believe that slowdown in growth (aftermath of demonetisation) and expected soft inflation could probably leave room for rate cuts by the RBI, which could augur well for duration strategies in 2017.

Meanwhile, there were credit concerns on individual companies during the year, however, improving credit ratio seems to indicate that we broadly appear to be in a credit upgrade cycle, though it could take time for credit cycle to pick up. Additionally, an anticipated fall in the lending rates post the currency swap exercise (increase in bank deposits) would help to bring down cost of capital for Indian companies, which in turn may bode well for the improvement of the credit environment and thus benefit accrual strategies.

The liquidity in the banking system has improved post demonetisation which would henceforth result in lower deposit and lending rates. However, given the cash rich nature of our economy, we could see some slowdown in the overall economic activity thereby weighing on the GDP growth. The trade-off between 1) likely positive impact of demonetisation in the form of lower interest rates over medium to long term and 2) pick-up in macro-economic growth, once the consumption gathers momentum, will be instrumental in shaping the direction of interest rates in 2017.

CPI inflation, which had been muted throughout the year, fell to a two-year low on account of softer food inflation. Further, given the good monsoon season and expected slowdown in consumption post currency replacement program, we believe that March’17 inflation could undershoot the RBI’s target of 5 per cent. However, the RBI seems to be concerned about inflationary risks. In the December monetary policy review, the RBI surprised by leaving policy rates unchanged stating that growth pain on account of demonetisation is ‘transitory’ and that there is enough demand in the system to make it worry over inflation. Going ahead, the RBI will assess the durability of the fall in inflation for implementing further interest rate cuts.

The rupee has depreciated close to 3 per cent against the dollar, however, it was among the better performing emerging market currencies in 2016. Higher crude oil prices and expectations of stronger US growth, coupled with earlier and more aggressive interest rate hikes in the US, may impact the rupee. However, contained twin deficits, improving domestic macro-economic indicators and the RBI’s reasonable foreign exchange reserves may provide some support.

Although India is in a relatively better position among the emerging economies, there are risks which can weigh on the Indian bond markets. We believe that faster than expected raise in interest rates by the US Federal Reserve, rising political uncertainty in Europe and OPEC’s deal on production cut could spike up the oil prices, thereby impacting the global bond markets. Meanwhile, at home the actual economic impact of the currency replacement programme will become clear in 2017 and the date of implementation of the goods and services tax (GST) could be pushed ahead. Nevertheless, the infusion of fresh deposits in the system (post demonetisation) is likely to shore up demand for G-Secs by banks, which could eventually augur well for bond prices.

Hence we recommend investors (who can withstand volatility) to consider duration bond/gilt funds for medium to long-term horizon. Although the lack of growth in private sector capex has delayed the pick-up in credit cycle, our corporate bond funds continue to offer reasonably high portfolio yields providing higher accrual income opportunities for the short to medium term.

The writer is Managing Director, Local Asset Management – Fixed Income, Franklin Templeton Investments, India

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