'Bond market investors are likely to chase yields in the coming months'

The RBI may need to step in with larger purchases soon to keep yields from rising.This size of weekly auction can be absorbed in the market only if there is confidence on low yields, he says

After a stellar rise in the equity markets since March 2020 low, BADRINIVAS NC, head of markets and securities services for Citi South Asia tells Puneet Wadhwa that the near-term upsides in the broader equity market remains capped and their model portfolio is overweight in select sectors like financials, telecom, industrials, and healthcare. Edited excerpts:

Did the Reserve Bank of India’s (RBI’s) recent stance on rates come as a surprise?
 

The recent pause by the Reserve Bank of India (RBI) in interest rates was no surprise, given inflation is higher than the targeted band. It is not easy to predict the future trajectory of CPI in the current situation, though one expects that price pressures will abate in the coming months as supply side bottlenecks reduce. On the other hand, growth continues to be extremely weak and the output gap has widened. The economy can ill-afford to have interest rates move higher in such a scenario. In fact, there is probably a need for further reduction in rates in future. Hopefully, headline CPI will moderate by the December 2020 quarter this year, making it easier for the Monetary Policy Committee (MPC) to focus on supporting growth.

How are the bond markets likely to play out over the next couple of quarters?

Bond markets have remained incredibly stable despite the record size of weekly borrowings. I do see market appetite waning in the second half of this fiscal. The RBI may need to step in with larger purchases soon to keep yields from rising. This size of weekly auction can be absorbed in the market only if there is confidence on low yields, else negative sentiments become self-fulfilling. I don’t think the RBI will let that happen – they have enough tools to anchor expectations and hold yields at, or near, current range.

Do you see a wider fiscal deficit by the end of fiscal 2021 (FY21)? What are the implications for the debt / fixed income segment?

Wider fiscal deficit is a distinct possibility but it is difficult to guess where it will finally land in FY21. To be fair to the Government, it is difficult to plan and manage finances on account of the uncertainty. A prolonged return to normalcy and subdued growth creates a double whammy impact of lower revenue mobilisation and higher expenditure for support and stimulus to various sections of the economy.

If so, how do you think the policymakers could address this issue?

Beyond the routine financing routes, direct debt monetisation and tapping into offshore liquidity pool are incremental options available. We should look to leverage the current global financial conditions of easy liquidity and ultra-low interest rates, and ensure we get a fair share of the global liquidity pool. The relatively high nominal rates that India offers, along with reasonably stable currency, are strong incentives for global investors. It’s really a win-win. The Government announced the intent to get into the global bond indices in the Budget and has started to take necessary steps. It would be good to have a specific roadmap and timelines for this. Higher fiscal deficit is a global phenomenon and most countries have ensured there is substantial counter-balancing monetary expansion, to finance the deficit and bring down interest rates. I do think India can use this tool judiciously in the current situation, to avoid any short-term impact to the domestic debt market.

Moody's expects APAC high-yield non-financial corporate default rate to hit 8.1 per cent in 2020. Are the financial markets factoring in the possibility?

To a large extent, yes. The spreads on AA and below-rated corporate bonds over Government (GOI) securities have gone up substantially. The widening of spreads in lower-rated credit names reflects the expected higher stress in these corporates. Having said that, the various measures announced by the Government and the regulators have helped in easing some of the pressure in the market. In the offshore Asia bond market, we have seen a significant compression in spreads. Given this pandemic impacts some industries substantially more than others, the market is increasing making name-specific differences on credit pricing and liquidity.

What has been your investment strategy since the past few months? Do you see investment-worthy avenues shrinking going ahead?

Generally, we have been long fixed income with more substantial positions in the front end of the curve, while being nimble on corporate bonds and in selective names. In the broader market context, investors are likely chase yields in the coming months and we are already seeing signs of it.  As the Covid-19 risk reduces, investors would look to lock into longer duration offerings. I still think the steep yield curve provides opportunities for investors, especially if we get some sell off in the near-term due to high inflation prints. While we believe near-term upsides in the broader equity market is capped, our model portfolio is overweight in select sectors like financials, telecom, industrials, and healthcare.

Do you expect banks and non-bank finance companies (NBFCs) making an aggressive provisioning for bad loans over the next few months?

It would be very difficult to make a general judgement. Banks that have raised capital aggressively recently could probably use the room more. The important aspect to watch out will be the health of the small business and retail sectors, if the extended delay in returning to full normalcy and corporate belt-tightening leading to further fall in consumption demand.

Are the bond markets factoring in continued liquidity by the global central banks at this stage?

Elevated asset prices across most asset classes including equity, precious metals and fixed income reflect the expectations of continued liquidity and monetary support by global central banks. While there is likely to be volatility around the US elections, any impact on flows to Emerging Markets (EMs) would be a function of how the dollar behaves. Even if there were some short-term impact, the size of our forex reserves provide sufficient cushion to ward off any material impact to our bond markets.

What are the other risks that investors should be aware of?

The other big global risk factor to watch out for is inflation, given the large size of fiscal and monetary expansion in the US. The high M3 growth, rollback of benefits of globalisation and behavioral changes post Covid-19, all create conditions for a pickup in inflation. This could lead to a sharp spike in global yields with steeper curves and would have implications for Indian bond markets too.

Now that the RBI has allowed restructuring, how will it reflect on the domestic corporate bond market? Will risk aversion and yields on such instruments ease?

Participation of capital market investors in credit funds has substantially reduced in the last few months and there has been a flight to quality within the credit universe as well. In absence of any fresh inflows, the appetite for restructured names is quite limited. However, there could be select names where their immediate debt servicing capacity would be enhanced based on the new guidelines, drawing fresh investors.

Where do you see 10-yr G-Sec yield and USD-INR rate by end of December?

The broad range for the 10-yr G-sec from now to the year end is likely to be 5.60% to 6.10%. The scale of RBI’s OMO purchases will have a big influence on yields. The RBI is expected to continue to grow its forex reserves position and accordingly the USD/INR could drift towards 76.0 by end of December.