While yields on short-term Indian government bonds are falling like there is no tomorrow, those on longer-term bonds remain sticky. This has led to a steep yield curve – the sort that the country has not witnessed at least in the past two decades. A steep yield curve has implications for investors. The country has witnessed steep yield curves twice in the past, and each such occasion was followed by a stunning bull run in equities. To quote a popular saying, history does not repeat itself but it does tend to rhyme.
The first instance: Between 2003 and 2005, yields on short-term government bonds had fallen to historic lows and the yield curve was steep. The spread between short-term bond yields and long-term bond yields was close to 2 percentage points (or 200 basis points). While the three-month government bond yield was at four per cent, the 10-year G-Sec yield was at six per cent. At this point in time, investors were wary of investing in the equity markets. The Y2K bubble had burst and 9/11 had happened. Between 2000 and 2003, bonds delivered double-digit returns. Towards the end of the bond market rally, equity investors booked losses in equities and entered long-duration bond funds at high net asset values (NAVs) at a time when yields had already bottomed out. Over the next few years, it was the equity markets that delivered one of the strongest rallies ever. The Sensex went from 3,000 to 21,000 over the ensuing four years. From mid-2006 onwards, investors booked losses in bond funds (because yields had risen) and shifted large amounts of money into equities. This was a time when the IPO (initial public offer) boom was on in the markets. Come 2008 and equity markets fell off the cliff. Investors thus lost money both in bonds and in equities.
Wrong timing once again: As equities crashed in 2008, yields also declined. So, while equities delivered negative returns, longer-duration bond funds gave returns as high as 40 per cent during the second half of 2008. During this period, investors saw the value of their investments in equities decline at the same time when net asset values (NAVs) of bond funds were rising steeply. In 2009, investors moved out of equities (booking huge losses, of course) and entered long-duration bond funds, when their NAVs had already risen to high levels. By this time, yields had already crashed to levels that were even lower than in 2003. The yield on the three-month treasury bill was at three per cent while the 10-year G-Sec yield was at around 5 per cent. In other words, the difference in yield between these two bonds was two percentage points (or 200 basis points). At a time when retail investors had abandoned equities, the Sensex once again zoomed from 8,000 to 20,000 over the next two years, starting from January 2009. Small investors were bystanders in this rally as well.
Steep curve once again: Currently, the yield on shorter-term bonds is below three per cent. The slope of the yield curve is also the steepest, with the difference between the three-month treasury bill and the 10-year G-Sec being three percentage points (or 300 basis points). The yield curve was not as steep either in 2003 or 2009.
Equity markets are once again on tenterhooks due to the global pandemic. The fear that there may be a second wave of the pandemic, which may be more severe than the first, has dampened investor sentiment. But could 2020, during which we have witnessed a global pandemic, cyclones, locust attacks, earthquakes, and intensification of the trade wars turn out to be another belter of a year for equities? And will retail investors manage to participate in the rally this time?
Unclear picture: It is a tricky situation. The market is deriving its adrenaline chiefly from the injection of liquidity. The system is flushed with liquidity, as can be seen from the fact that every day more than Rs 7 lakh crore is parked in the Reserve Bank of India's reverse repo window. So, while the fundamentals are weak and should, in the normal course, cause equity markets to crash, liquidity support is very strong, due to which the equity markets are holding firm.
GDP data for FY20 was poor, as was widely anticipated. The economy may contract in FY21. This is a development that most investors will experience for perhaps the first time in their lives. The outlook remains bleak across sectors. Not a day goes by without news of some company or the other laying off employees.
In times of such economic distress, it is difficult to justify the current market valuations. But with so much liquidity sloshing around, it is unlikely that the markets will witness a sustained fall for a prolonged period of time. A steep yield curve also means that banks can borrow cheaply for the short-term and lend at higher rates for the long-term. Bank profits could rise. The S&P BSE Bankex is among the worst-performing sectoral indices over the past year.
Looking back at the markets in 2003 and 2009, index valuations were quite low just before the equity markets rallied: The Nifty PE was between 10 and 14 times on both these occasions. Retail investors were averse to equities. Neither of these two conditions prevails today. Equity markets are not trading at very low valuations, nor are retail investors fleeing from this asset class. So, empirically, the equity markets may not have bottomed out yet.
In such circumstances, instead of betting on current valuations, investors should run systematic investment plans (SIPs) so as to average out their cost of purchase. If they don't want the trouble of selecting an active fund, they should go with an index fund. Second, at a time when markets could plunge, quality stocks can provide a good hedge to one’s portfolio. High-pedigree stocks tend to weather a storm relatively better. And even if they fall, these stocks tend to be picked by value seekers first. Third, if the portfolio size (including both direct equities and equity mutual funds) is bigger than Rs 25 lakh, the investor should consider hedging his portfolio.
In the case of a large and sudden fall, many retail investors tend to panic and sell their equity holdings. If your portfolio is hedged, you will not need to worry even if the market cracks. It is like having a raincoat while going out: Whether it rains or not, you are not affected.
While it is good to take precautions, we should not forget the lessons of history. Bull markets are born in the depths of pessimism. Staying invested in equities is important. Even if retail investors made mistakes in 2003 and 2009, they should get things right the third time in 2020.
The writer is a sector expert with the Department of Economic Affairs-National Institute of Financial Management Research Programme