Higher volatility to persist due to fiscal slippage, says Pankaj Sharma

Bonds do not like fiscal indiscipline and the same is reflected in the rise in yields, says Pankaj Sharma, CIO. Edited excerpts

Bonds do not like fiscal indiscipline and this is reflected in the rise in yields, says PANKAJ SHARMA, chief investment officer (fixed income), DSP BlackRock Mutual Fund. A reversal in the interest rate stance may happen sooner than later, he tells Ashley Coutinho in an interview. Edited excerpts:

The bond market has seen a lot of action as the government’s fiscal math did not play out as expected. Will this volatility continue?

There is an upward shift in the Centre’s fiscal deficit from their earlier glide path for FY18 at 3.2 per cent and FY19 at 3 per cent. Bonds do not like fiscal indiscipline and it is reflected in the rise in yields. The recent worries have been compounded with elevated commodity prices; especially that of crude oil.

There is a risk on account of the effect of the proposed increase in minimum support prices (MSP) and fiscal slippage in an election-heavy period and its effect on inflation. The bond market likes predictability. Given the uncertainties, a higher volatility is likely to persist.

What is the trajectory of interest rates? Some analysts expect the Reserve Bank to tighten rates between October and December, or even before.

Macro variables have moved towards the negative territory over the past two months. This includes rising crude oil prices, yields in developed markets moving north, fiscal slippage, and prospects of a change in MSP mechanism.

We maintain a bias for reversal in the interest rate stance sooner than later. Bond yields have been pricing the same and the policy outcome for now will resist hardening of yields from the current levels. We expect gilt yields to come under pressure as the government auctions resume in April.

The consumer price index (CPI)-based inflation rose to 5.07 per cent in January. Will there be more inflationary pressures?

As the growth momentum reverses benefiting from re-monetisation, it will be accompanied by a rise in inflation. Higher CPI prints in the recent past can also be attributed to seasonality as well as statistical factors. Statistical factors have a measured shelf life and wane out over a period of four quarters. So, a rise in inflation, especially in the first quarter (Q1) of FY19, will be predominantly driven by the base effect.

Two dominant factors that will drive the near-term inflation dynamics are crude oil prices and MSPs for kharif crops, which will be defined in Q1.

Foreign portfolio investors (FPIs) have been net buyers in the debt markets this year. Do you see this trend continuing?

High participation by FPIs in the Indian debt markets was driven by high carry and a stable USD/INR exchange rate. For an offshore investor, the rupee appreciation has contributed more towards total returns against rates/carry.

A stable currency, higher (real) rates, and a sound macroeconomic environment form an ideal combination for FPI inflows. Over the past few years we have demonstrated the best of these combinations. As things stand, FPIs have been utilising more than 90 per cent of the debt limits. If we are able to demonstrate the ideal combination, then opening up of further limits will aid a strong trend of FPI inflows in debt.

India’s external balance sheet has improved considerably since 2013. However, a recent deterioration in current account deficit is a cause of concern as the focus will shift to currency risk.

It is being considered to make it compulsory for corporates to tap the bond market for part of their capital requirement. Will this help deepen the bond market?

We will have to wait for more details. The moot issue is that of price discovery — both in the primary and secondary markets. As fixed income products move from defined-benefit to market-defined products, price discovery becomes that much more important. The existing fixed income market is controlled in the longer end by institutional players like insurance companies and provident funds. The shorter end is with the mutual funds and there is no one in the middle, other than some proprietary positions by banks.

The fixed income market has limited price discovery, restricted to certain securities and issuers. Since valuation guidelines are not uniform, same security held by a bank, mutual fund, insurance company and a pension/provident fund, could be valued at different prices. Efforts should be made to have uniform pricing across securities; this will promote transparency and eventually lead to better liquidity.

What is your advice for debt investors?

Accrual, capital gains, and trading are the three drivers for bond fund returns. With the reversal in rate scenario on the anvil; bond funds will have increased exposure to low-duration high-accrual assets. With the repo rate at 6 per cent and the money market rates close to 7.5 per cent; markets are pricing at least one rate hike at current levels. Funds bearing higher allocation to money market rates and short-tenor bonds would be considerably lesser exposed to volatility.
 

Duration yields continue to look enticing with benchmark 10-year yields trading close to 7.5 per cent. Unless markets get a wholesale buyer for the duration, we expect volatility in duration assets to persist. Hence, the duration segment would remain underweight until the demand-supply equation for long-duration bonds improves. 

The 10-year benchmark US treasury note yield is near its highest level in four years. How will this affect global bonds?

In the last few weeks, rising yields in the US have created heightened volatility across markets. The US Federal Reserve is expected to do four hikes in 2018, taking the federal funds target rate range to 2.25-2.5 per cent. Any divergence from consensus creates volatility, normally seen when a turn in rate cycle occurs.

The empirical evidence might not show much correlation between the US and INR rates. But global markets are more interconnected today than ever before. Perhaps, the foreign exchange market will price higher US rates first. There may be an effect on INR rates in the short term, but domestic investors and our internal policies and their outcomes, define the medium- to long-term interest rates trajectory in India.

Emerging markets can withstand narrowing yield differential with that of developed markets in times of strong macro-stability. A recent pause in fiscal consolidation and prospects of a rise in inflation would remain detrimental for narrowing yield differential between the Indian and the US treasury yields. Hence, a rise in US yields will imply a pressure on rising bond yields.