Analysis. RBI policy: A mixed bag for bond markets

The yield on the benchmark 10-year government security (G-Sec) hardened by 16 basis points (bps) to 7.99 per cent, a day after RBI’s Monetary Policy Committee (MPC) announced 25 bps hike in the repo rate.

While the hike in the repo rate — a first in the past four years — contrasted the market expectation of a pause in the bygone policy, it was equally surprising to see a unanimous vote by all members for a rate hike.

The increase in RBI’s projection of consumer price index (CPI) inflation for H2FY2019 to 4.7 per cent from 4.4 per cent and a neutral stance on monetary policy suggest that future rate action would be data-dependent.

Nonetheless, with the recent monetary tightening and consequent rise in G-Sec yields, lending and deposit rates of banks are likely to move up.

The spread of 175 bps between the policy rate and the benchmark G-Sec is much higher than the historical average of 50-60 bps. If inflation remains within the projected levels, the benchmark bond yields need to cool down, which in turn may require market interventions by the RBI in near-to-medium term.

Muted funding

Nonetheless, the hardening of the benchmark G-Sec yield has also fuelled an increase in the corporate bond yields. With the capital constraints of public sector banks and their consequent limited ability to support credit growth — particularly for those under the PCA (Prompt Corrective Action) framework — funding availability from the banking system is expected to remain muted, especially for lower-rated firms.

Even in a scenario in which private banks grow their advances by 20-25 per cent during FY2019, the overall credit growth from the banking system is expected to remain limited to 7-8 per cent.

In an increasing global bond yield scenario and given some pressure on exchange rates, the borrowings from the external commercial borrowing route may also not be attractive. In such a scenario, higher-rated corporates are likely to tap into the domestic bond market, despite elevated domestic bond yields, which is likely to further push up yields in domestic bond markets.

Apart from the rise in long-term rates because of the rise in the benchmark G-Sec, short-term rates have also witnessed an increase on the back of reducing liquidity surplus and calibrated increase in the liquidity coverage ratio (LCR) requirement for banks. The guideline to include another 2 per cent (in addition to the existing 11 per cent) of their SLR (statutory liquidity ratio) holdings for calculation of LCR should improve the LCR for banks and reduce pressure on short-term rates.

SDLs

In another development, the RBI has proposed revised norms for valuation of State Development Loans (SDLs), which hitherto were valued at a uniform spread of 25 bps above the yield of G-Sec of similar maturity. Going forward, these SDLs will be required to be valued at the actual yields based on the traded price in the secondary markets. In case any SDL is not traded, the valuation of such SDL will be based on the State-specific weighted average spread determined in primary auctions of similar maturity.

Given that the actual spreads in the primary auction of SDLs or secondary market of SDLs is higher than 25 bps (40-50 bps in auction and 70-80 bps in secondary markets), the appetite for these SDLs may also reduce, thereby prompting a higher yield in primary auctions. Further, the RBI has proposed public ratings of SDLs, which would bring in much-needed differentiation in SDL bond yields based on the market’s assessment of the credit profile of States. This would also aid in widening the spreads in the SDL market that tend to be quite narrowly clustered at present.

Based on the trend in global bond yields and the outcome of domestic inflation levels, the interest rate environment and the outlook on bond yields appear set to harden. The domestic inflation trajectory would be driven by the progress of monsoons, the revision in minimum support prices for various crops, the movement in crude oil prices and the evolution of fiscal risks. A further upward revision in the inflation forecast because of the aforesaid factors may prompt the MPC to further hike the repo rate, which would push up the yields across various borrower categories.

While the RBI has allowed banks to amortise the marked to market losses for Q1FY2019 over the next four quarters, it would also need to increase its open-market operations. This will ease the relative liquidity tightness in the market and the supply overhang of G-Sec, given a back-ended government debt issuance programme this fiscal.

With the likely rise in interest rates, retail bond investors — especially the ones who hold to maturity — will also get an opportunity to lock in better yields on their investments during this fiscal.

We have already seen a few public issuances of debt in the current fiscal; expect more entities to use this route to raise funds. However, they need to be choosy on the underlying companies, and invest in debt issuances of entities with sound credit ratings.

The writer is Senior VP, Group Head, Financial Sector Ratings, ICRA Ltd.

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