Low duration funds were hit sharply by rise in yields at the short end of the cure. Credit Risk funds were hit badly by IL&FS default leading to high credit risk aversion that saw spike in yields across credits, especially NBFC credits. CP yields rose on credit worries and liquidity issues as markets froze on risk aversion. CD yields rose on system liquidity worries. Short maturity bond yields rose on credit and liquidity worries. Credit spreads rose, leading to government bond outperforming corporate bonds. Outlook for credits remain uncertain though liquidity will ease in October on RBI bond buying, government spending and release of half year end hoards by the banking system. Liquid funds and gilts funds are best suited in this environment.
The 10-year G-sec yield rose in September 2018 with the yield rising by 2 bps from levels of 8.01% in 3rd September to close the month at 8.03%.
Negative Drivers of G-sec Yields
USD-INR INR in the month of September fell to its record low of Rs 73.12 intraday, due to heavy sell-off in emerging market currency as demand for safe-haven assets increased on a combination of factors such as intensifying US-China trade war, higher crude oil prices, Turkey and Argentina crisis and hawkish policy stance by Fed and ECB.
In FY 2018-19, due to oil prices rising, and trade wars hurting risk sentiments and worries on EM economies, the INR saw trend reversals, and this led to unhedged FII flows seeing reversals as FIIs sold INR Bonds to limit losses. The selling by FIIs took up bond yields, which led to further selling. The INR too started falling rapidly on FII bond sales.
To protect the INR slide, the government announced a plan to cut down non-necessary imports, ease overseas borrowing norms for the manufacturing sector and relax rules around banks raising masala bonds, or rupee-denominated overseas bonds.
FII Turn Net Sellers of Bonds in September–
In the fiscal year 2017-18, FIIs pumped in money into INR Bonds, taking up limit utilization (limits were enhanced to attract flows), which in turn helped strengthen the value of the INR. Debt flows are leveraged and despite a clear lack of interest rate arbitrage, FIIs bought into INR Bonds on a positive outlook for the INR as the oil prices were down, current account deficit was low and capital flows helped increase the value of the INR. In fiscal 2018-19, the whole scenario changed. Fx reserves that were built up in fiscal 2017-18 saw falls with RBI turning net seller of USD from being a net buyer last year.
Debt flows can be extremely harmful if not monitored properly and that is one of the reasons why the RBI is reluctant to increase debt limits substantially.
Global Central Bank Policy is Squeezing Global Liquidity –
Federal Reserve raised the federal funds rate by 25bps to 2% to 2.25% during its September 2018 policy meeting, in line with market expectations, this is the 3rd rate hike in the year 2018, and it is the 8th time the Federal Reserve raised borrowing costs since it started in late 2015, it held rates near 0% after the 2008 recession to speed up the economic recovery.
The rate hike was expected as US economic growth is strong, Unemployment is low, and inflation is relatively stable. Fed rate-hike outlook for the rest of 2018 and 2019 stayed the same as well. The central bank is expected to raise rates again in December and another three times next year. The Fed economic outlook has improved. GDP growth for 2018 is now expected to come in at 3.1%, up from the previous expectation of 2.8%.
ECB– The European Central Bank has kept the policy unchanged as expected ECB announced plans to end bond purchases at the end of the year and keep interest rates at record low levels at least through next summer. The bank also confirmed it will halve bond purchases to 15 billion euros ($17.4 billion) per month from October.
Positive Drivers Drivers of G-sec Yields
CPI Inflation– Consumer price inflation came in at 3.69% in August 2018, compared with 4.17% in July 2018. However, Core CPI inflation came in at 5.90% in June 2018 from 5.70% in July 2018.
Inflation is currently running below the MPC forecast of 4.6% in Q2 FY-18. The MPC projects inflation at 4.6% in the September-ending quarter and 4.8% in the second half of 2018-19.
RBI will keep an eye on the impact of MSP hikes as its impact would only be known after procurement is done. This increase in MSPs for Kharif crops, which is much larger than the average increase seen in the past few years, will have a direct impact on food inflation.
India Q1 GDP– Indian economic growth rose to 9 quarter highs of 8.2% in Q1 FY-19 on the back of strong core performance and base effect. Economic activities that registered growth of over 7% are manufacturing, electricity, gas, water supply & other utility services, construction and public administration, defense and other services.
The growth in the agriculture, forestry and fishing, mining and quarrying, Trade, hotels, transport, communication and services related to broadcasting and financial, real estate and professional services is estimated to be 5.3%, 0.1%, 6.7%, and 6.5% respectively.
OMO and Lower Government Borrowing- RBI bought Rs 200 billion of bonds through OMO bond purchase auctions in September, taking up total bond purchases to Rs 500 billion in the first half of this fiscal year. Government reduced its gross borrowing by Rs 700 billion for the second half of this fiscal year.
Outlook for G-secs – OMOs and lower government borrowing will provide support to bond yields in the near term but markets will stay nervous on rate hike worries. Measures to bring in capital flows will not help the INR unless risk aversion eases.
The bond yield will stay volatile as the market worries about rate hikes by the RBI, government borrowing for the 2nd half of the fiscal year and global issues including Fed rate hikes and trade wars.
RBI is expected to hike rates in October despite CPI inflation for August falling below 4%. Core CPI at 6% levels and steadily falling INR on capital outflows due to global risk aversion will drive the RBI to hike rates. However, the worst may have passed for bond yields and markets are unlikely to witness the huge volatility seen in the last one and half years.
Credit Markets Facing Volatility Post IL&FS Default
A few months back IL&FS was rated AAA (highest rating) and in August 2018 its rating was downgraded to AA+ and now its rating is downgraded to default. Its subsidiaries ratings too were downgraded to default.
Volatility shifted to credit markets last week on the back of contagion effect of IL&FS default. Yields on DHFL CPs and bonds spiked on as rumors of liquidity issues with the company hit the market. The company management were quick to clarify their liquidity position to calm nervous markets, but the damage had been done and nervousness on credits will continue for a while.
The debt default by IL&FS cannot be ringfenced with the lenders taking the hit, as in the case of banks bad loans. The public has a direct stake in IL&FS debt, as MFs have invested in the debt and the default has hit public investors in MF schemes that have been affected by the default. IL&FS default has unnerved investors who are looking suspiciously at all debt securities held by MFs, whether they are rated AAA or BBB.
Outlook for Corporate Bonds- MFs were receiving good flows into their credit risk funds that were deployed in lower rated assets and flows into credit funds will stop going forward. The effect of lack of flows into credit funds is the higher cost of borrowing for issuers especially at the lower end of the rating scale, which will drive credit spreads higher. The corporate bond market will take a hit given that most of MFs fixed income corpus is deployed in corporate bonds.
Outlook for CPs & CDs- MFs are the largest lenders in the CP market and if there is lack of liquidity amongst MFs, working capital for companies may dry up if MFs go slow in CP investments. Issuers will then have to pay higher cost for borrowings, leading to lowering of profitability and postponement of capex. CP spreads will stay high until risk aversion eases. CD spreads will trend down on easing system liquidity and flight for safety.