The first budget of the Modi government is to be presented to the parliament on the 10th of July 2014 and bond markets are pricing in a period of slow growth and inflation coming off down the line. Yield curves that plot the yield and time to maturity of similar rated bonds are flat and that provides an opportunity for fixed income investors to take a longer term directional call on yields.
Government bond yields are trading at levels of 8.6%, 8.36%, 8.6%, 8.7% and 8.75% for 1,3,5,10 and 30 year benchmark securities. Corporate bonds yields are trading at levels of 8.95%, 9.10%, 9.18% and 9.15% for 1,3,5 and 10 year benchmark AAA bonds.
(Image 1 Government Bond Yield Curve)
(Image 2 : Corporate Bond Yield Curve)
The difference between 1 year and 30 year government bond is just 15bps in the government securities market and the difference between 1 year and 10 year corporate bond is just 30bps in the corporate bond market. The low spread difference between 1, 10 and 30 years bonds is typically called a flat yield curve.
Why this flat yield curve? Why are bond investors content to buy 30 year government bonds at 8.75%, when 1 year, 5 year and 10 year government bonds are available at 8.6%, 8.6% and 8.7% yields? The common notion is that the longer the maturity of the bond, the greater the risk of inflation and hence higher the yield on the bond as investors demand risk premium?
In the current scenario in India, there is a problem of slow economic growth and high inflation. (Read the analysis of Prof. Naveen Srinivasan on why India has slow growth and high inflation). GDP growth has come off from levels of over 8% to below 5% in the 2010-11 to 2013-14 period while CPI (Consumer Price Index) inflation has averaged around 9.5% over the same period.
The Modi government has to take a tough stance to bring down inflation, as it is essential for long term sustainable growth. RBI is very clear on its target for CPI, which is 8% and 6% in March of 2015 and 2016. CPI is currently at levels of 8.28% as of May 2014. Hence the first budget of the Modi government to be presented by the Finance Minister Arun Jaitley is likely to focus on fiscal consolidation, as high fiscal deficit was one of the primary reasons for the economy showing slow growth and high inflation. (Read FII limits in gsecs will have to be increased to fund fiscal deficit to understand why deficit is a big problem in India).
RBI will keep monetary policy on an anti inflation path and its policy rate, the repo rate, is likely to stay at current levels of 8% for a while. Liquidity will be enough for the system but not excessive so that the repo rate will be the operational rate and policy transmission can take place.
The bond markets are effectively factoring in a period where fiscal deficit will be contained at the cost of short term economic growth and operational rate for money markets will be around repo rate levels of 8%. The bond market is also anticipating a decline in inflation going forward as government and RBI steps on lowering inflation expectations take effect.
Hence bond investors are buying 30 year government bond at 8.75% levels as the expectation is that inflation will come off and bond yields will fall in a couple of years time. At the same time, 1 year bond yields are factoring in a period of stable repo rate of 8% with liquidity being adequate but not excessive.
A fixed income portfolio that has a weight of 55% in 2 years to 5 years maturity government and corporate bonds and 45% in 10 year and above maturity government and corporate bond will be an ideal portfolio for you, if you are looking at a 2 year plus horizon. Fixed income mutual fund investors can have 55% weight in short term bond funds and 45% weight in long term bond funds.
(Follow our fixed income growth portfolio for a model fixed income portfolio).
Investments in liquid funds or fixed deposits should be only for managing short term liquidity.