Reading our articles, you might be well aware that Reserve Bank of India's (RBI's) decision to change interest rates are based on the broader economic factors like economic growth, inflation, fiscal deficit, reforms etc; which play a major role in controlling market sentiments. Hence, before taking any decision to invest in debt securities, it is important to understand the various constituents and factors affecting the bond markets. While debt as an asset class is known for safety and assured returns, there are various economic factors that impact the value of the debt instruments and thereby the debt markets:
 

• Prevailing yield on Government Securities and bonds across maturities
• Borrowing and spending programme of the Government in a fiscal year
• Macroeconomic variables viz. economic growth, inflation, fiscal deficit etc.
• Monetary policy of the RBI
• Liquidity conditions in the system, etc
   

Debt market investing follows a simple theory - 'Price and Interest Rates are inversely related' i.e. the bond price and bond yield move in opposite direction. A fall in prevailing yield on the bonds increases its price, thereby making gains for investors. On the other hand, a rise in the prevailing yield on the bonds diminishes the bond price, thereby leading a loss to the investor. One should carefully monitor the Interest rate movement in the economy and then invest in mark to market securities depending upon their tenure which can be short-term, medium term or long-term.

What we witnessed...

The year 2012 saw the Indian debt markets full of expectation with very low contentment. The bond markets expected early action from the government which was facing serious policy paralysis. It expected the RBI governor to cut policy rates, to release some cheer in the market; but they faced disappointment on most of the occasion. However, while the government acted late by passing some important bills, the RBI governor did justice to his role even under pressure conditions with a sole aim of keeping inflation under control. The initial liquidity pressure (which pushed the rates on short term instruments to over 10%) in the 1st and 2nd quarter of the calendar year was well answered by the RBI through multiple cuts in Cash Reserve Ratio (CRR) which helped infuse liquidity in the system, supported by series of Open Market Operations (OMOs) and increase in Marginal Standing Facility (MSF) limit which further added some cushion to liquidity. In the last calendar year, RBI cut CRR by 175 bps and SLR by 100 bps.
 

Key Debt Market Indicators

	As on Dec 30, 2011	As on Dec 31, 2012	Change
Exchange rate (Rs/$)	53.06	55.00	-3.66%
Repo Rate	8.50	8.00	(50 bps)
Reverse Repo Rate	7.50	7.00	(50 bps)
CRR	6.00	4.25	(175 bps)
SLR	24.00	23.00	(100 bps)
10-yr Gilt yield	8.52	8.05	(47 bps)
5-yr Gilt yield	8.34	8.03	(31 bps)
Call rates	8.20	9.00	80 bps

(Source: CCIL, Reuters, Bloomberg)  

The RBI which began its war against the inflation bug by hiking Repo and Reverse Repo rates 13 times (by 375bps) between during March 2010 to October 2011 provided a relief of just 50 bps in Repo and Reverse Repo rates in C.Y. 2012. The original fiscal deficit target for the year 2012-13 (set in the budget at 5.1%) which clearly looked unfeasible was revised (post change in finance ministry) by Finance Minister P. Chidambaram to 5.3% in view of the fiscal challenges posed by slowing revenues and higher subsidy burden. But even achieving fiscal deficit target of 5.3% of GDP seems challenging for the Government. The government borrowed Rs 3.7 lakh crore (65% of budgeted) in the first half of the fiscal year and is trying to accommodate within the planned gross borrowing limit of 5.69 lakh crore for 2012-13.

The fiscal challenges and government in action...

India's current account deficit in the quarter ended September 2012 has already widened to a record high of 5.4% of GDP, as export growth slowed more sharply than imports, and a similar gap is expected for the quarter ended December 2012. The high deficit puts pressure on the government while it tries to push the long awaited reforms to protect the nation from a sovereign rating downgrade due to high twin deficit (both current and fiscal). A rise in gold and oil import bills and tumbling exports due to global slowdown have kept India's current account deficit at stubbornly high levels.

As per the data released by Controller General of Accounts (CGA) at the end of December, India's fiscal deficit in the first eight months of the current fiscal (April-November period of 2012-13) stood at Rs 4.13 lakh crore or 80.4 per cent of the Budget Estimates (BE). The deficit numbers however showed a slight improvement vis-à-vis the fiscal deficit position last year (which was 85.6 per cent of the Budget Estimate) and was mainly attributed to some tightening on the expenditure front. The government forced measures like rationalization of expenditure and optimization of available resources to improve fiscal deficit condition. It contains 10% mandatory cut on non-plan expenditure in the fiscal year, ban on holding meetings and conferences at 5-star hotels, ban on creation of plan and non-plan posts and restrictions on foreign travel. In the recent past the government also took some tough decisions like hiking diesel prices by over Rs 5 per litre and imposing cap on the number of subsidised LPG cylinders to six per family in a year, which helps reduce its subsidy bills.

During the April-November period, while the government's total expenditure stood at Rs 8.67 lakh crore, it could manage Net tax receipts of just Rs 3.7 lakh crore. The government which set a target of mopping up Rs 30,000 crore through disinvestment in the current fiscal saw a delay in agenda due to some administrative ministries raising concern over weak market conditions and sectoral uncertainties. It took around 8 months for the government to make the first disinvestment of the 2012-13 fiscal. It has so far mopped up around Rs 6,808 crore (Rs 6,000 crore by 10% stake sale in NMDC and Rs 808 crore through 5.58% stake sale in Hidustan Copper Ltd). Apart from this the cabinet has already cleared stake sale proposal in Oil India, National Aluminium Company, Rashtriya Ispat Nigam Ltd (RINL), SAIL and trading firm MMTC in this fiscal. The government had to defer the IPO of RINL sighting weak market conditions. Raising adequate funds from disinvestment program is necessary to keep the fiscal deficit in check as it faces pressure due to rising food, fuel and fertiliser subsidy bills. The government is however confident of meeting its target of raising Rs 30,000 crore through the sale of its stake in state-owned companies in the current fiscal.

The fiscal consolidation measures recently adopted by the government, since the time Ms. Mamta Banerjee's TMC, pulled its support from the UPA, demonstrates its unquestionable will towards reforms. After much debate, the government managed to pass the FDI bill in Retail and Aviation Sectors. It put a focused PSU stake sale program to raise funds and set Constitution of Cabinet Committee on Investments to monitor large projects. It also passed the Companies bill and Banking Law Amendment bill, provided Stage I Forest clearance to few large coal blocks; and took some harsh measures like deregulating diesel prices and allowing oil companies to raise prices of diesel to reduce their under recoveries, and imposed ceiling on subsidised LPG cylinders which can significantly cut the subsidy bill of the government. The government's mechanism to transfer subsidies directly to the intended beneficiaries by using the unique identification card or "Aadhar" can thereby significantly improve the efficiency of subsidy distribution; which may decline the Subsidy bill's that account for nearly 1.8% of the annual budget. The government is also eyeing to lower the fiscal deficit in 2013-14 by lowering fiscal expenditure and increasing tax revenues. In the fiscal budget 2013-14 (to be presented on February 28, 2013), the government is likely to project a fiscal deficit of around 4.7% - 4.8% of GDP.

The growth dynamics...

(Source: CSO, PersonalFN Research)  

The nation's growth has slowed down. While the industrial growth has remained in the negative zone in 6 out of the past 12 months, the economic growth is shrinking to below 5.5% and agricultural growth is feeling the pain, due to scarce rainfall and ongoing cold waves. Despite the average growth of 5.4% achieved in the first 2 quarters of the fiscal, the central bank in its last policy held by its growth forecast of 5.8% for full year 2012-13, while the government expects the economy to grow no better than 5.7% in the current fiscal. To achieve a growth of 5.7% - 5.8% in the fiscal year 2012-13, the economy needs to show an average growth of 6.0% - 6.2% for the second half of fiscal year, which makes monetary easing more essential at this stage.

The persistently high inflation...

(Source: Office of the Economic Advisor, PersonalFN Research)  

The WPI Inflation moderated to 7.5% levels vis-à-vis 9-10% levels seen in 2011. The Inflation has been in the range of 7.2% to 8.1% in CY 2012 and has refused to show much relief despite sharp slowdown in growth, though it moderated to a 3 year low of 7.18% in December 2012. On the other hand the Retail Price Inflation stood at 10.56% in December due to higher food grain prices.

While the growth risks increased, the inflation risk persisted in the past year. Even though the monetary policy has an important role in supporting the growth revival, the RBI perceived that inflationary pressures was high along with risk from twin deficits i.e. current account deficit and fiscal deficit. Given the fact that the government is trying to do its bit by pushing the long stalled reforms that can help it address some of the RBI's worries, provides positive signal for the rate cut expectations.

The RBI's action...

(Source: Office of Economic Advisor, RBI, PersonalFN Research)  

After raising policy rates by 375 bps during March 2010 to October 2011 to contain inflation and anchor inflation expectation, RBI aimed to keep the WPI inflation under controllable levels and did its best on not letting the industry pressure drive its policy decision making, which it perceived to be in the best interest of nation. It answered the initial liquidity crisis by successive cuts in CRR (a total of 175 bps in the last year). While in its Annual monetary policy meeting (on April 17, 2012) RBI seeing sign of slight moderation in headline WPI inflation provided a token relief to the industry in the form of policy rate cut by 50bps in Repo and Reverse Repo. It did this with an objective to recoup the descending trend in India's GDP growth and slowing growth in industrial activity, thereby showing concerns towards economic growth dynamics. The high inflationary levels which remained above the comfort level of RBI remained a major reason for RBI to maintain status quo and keep differing its rate cut decision despite slowing growth. Now with the government providing series of fiscal reform measures to support RBI in its battle against high inflation, high interest rates and declining growth; and with the inflation moderating to a 3 year low puts a positive case for rate cut expectation from RBI in its next policy meeting. RBI had in its December 2012 policy review guided markets for rate cuts in January 2013.

The major question here is whether one can really expect an ideal policy action from RBI, when the sudden fiscal actions have been motivated more due to political reasons rather than economic reasons. Though the slowdown in economic growth and government's rollout of reforms has already fuelled rate cut expectations of upto 50bps in the upcoming monetary policy meeting, the RBI governor still considers inflation to be higher and thus may differ from providing immediate monetary stimulus to boost growth. Also with the lack of spending from the government in its ambition to bring down fiscal deficit, RBI has another reason to withstand the pain of low economic growth for some more time. The further stance of monetary policy will continue to be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamics, management of liquidity conditions to ensure adequate flows of credit to productive sectors, government spending's, deficit control and appropriate responses to shocks originating from external developments.

Where are the yields trending...

(Source: CCIL, PersonalFN Research)  

CY 2012 ended with the bond markets on positive note and investors making gains on their fixed income portfolio. The yields saw consecutive rally across maturity curve. The liquidity crunch witnessed in the first and second quarter of CY 2012 pushed yield on short term instruments to around 10% levels with investors making gains on their short term portfolio in the first half of the year. The latter half saw consolidation in the longer maturity instruments, and with expectation of further rate cuts from RBI (post Annual Monetary Policy in April 2012), the sentiment shifted towards longer maturity. Investors took position in longer maturity instruments which benefited investors who continued to hold their investments patiently till the end of the year.

Despite steps like several cuts in CRR and series of OMOs, the liquidity situation on most occasions in the past year continued to be well above the Rs 1 lakh crore levels (comfort level of RBI being at around Rs 60,000 crore). As RBI supported the liquidity by buying government bonds through OMOs, it chose to keep the CRR unchanged at 4.25% in its December policy review meeting despite tight liquidity in the system (before the monetary policy meeting in December 2012, the bank borrowings under Liquidity Adjustment Facility stood at over Rs 1,40,000 crore due to advance tax outflows). Towards the end of December 2012, the LAF borrowing nearly touched Rs 1,60,000 crore mark. Surplus money with the government and lack of spending has caused acute liquidity deficit in the system. In order to keep liquidity comfortable RBI will have to buy more bonds and is expected to announce more OMO purchase auctions to infuse liquidity into the system. It may further have to cut CRR from the current levels.

Akin to the tight liquidity conditions, the yields on the shorter maturity instrument is currently at decent levels. 1 month CD rates are currently at around 8.10%-8.15% levels, while the rate on 3 months CDs is prevailing at around 8.45%-8.50% levels. The longer duration yield have shown significant rally in the past year with swift rally over the past few weeks. The yield on 10 Year benchmark bond rallied from 8.35% in early Jan 2012 to 8.15% in Dec 2012. The 10yr G-sec yields traded in the range of 8.30% to 8.65% in the first half of the calendar year 2012 and 8.15% to 8.30% over the past 6 months and have now fallen sharply to below 7.9% levels triggering rally in bond prices. The swift rally since last week of December is indicating the renewed buying interest in government securities. The limit set for Foreign Institutional Investors (FIIs) to buy into government securities and corporate bonds have been recently raised by 5 billion USD each, which can encourage inflows and support rally.

Yields seem to be softening with expectation of seeing a cut in policy rates in the next policy meeting on January 29. If rate cut decision is differed by the RBI, it will provide a breather to the bond yields and the bond markets as the eyeballs will start rolling towards the fiscal deficit and borrowing numbers that will be presented in the fiscal budget 2013-14. More will depend upon the borrowing targets provided by the government for next financial year. The government seems to be committing itself towards lowering the fiscal deficit in 2013-14 by lowering expenditure and increasing tax revenues. Any mislaying by the government on its fiscal path may trigger a 25bps to 30bps upside move in benchmark yields. A 75bps to 100bps rate cut in CY 2013 can help ease bond yields on longer duration instruments, while yields on shorter duration instruments will become more attractive if liquidity continues to remain tight. Yields on shorter maturity instruments will continue to prevail at higher levels vis-à-vis longer maturity instruments.

What to expect...

Damage control initiatives taken by the government and RBI are expected to pay off over the next few months. The threat of overshooting its fiscal deficit target may have receded considerably for the government, and any additional reduction in fuel subsidy may further reduce the burden.

The government will aim to achieve the revised fiscal deficit target and hence may try to cut planned expenditure, increase revenue while maintaining borrowings at targeted levels. The borrowing calendar announced by RBI for the Q4 of FY 2012-13 does not throw any negative surprise. This denotes that government is unlikely to overshoot its borrowing limit by a big margin. It has planned to auction T-Bills worth Rs 1,40,000 crore and medium and long term G-sec bonds worth Rs 60,000 crore. T-Bills are short term in nature and usually are not used to bridge the gap in government revenues. The government is however expected to overshoot its fiscal deficit target of 5.3% set for FY 2012-13. This, when coupled with higher inflation in primary articles and fuel prices, limits the scope for monetary easing. Also, factory output measured by the Index of Industrial Production (IIP) is repeatedly failing to maintain consistency in growth and needs a boost in the form of accommodative monetary policy. We can hence expect a cut of 75bps-100bps in policy rates in 2013. Rapid growth in bank credit is often considered as an indicator of high growth expectation and robust business sentiment. Growth in bank credit in the year 2012 is expected to be one of the weakest in last 3 years. Asset quality concerns still linger. In 2013, we can expect a slight uptick in bank credit. As per the World Bank estimates, India's GDP would grow at 6.4% in FY 2013-14 as against the growth of 5.7% expected to be achieved in the current fiscal; while we expect a recovery in 2013-14 GDP growth to 6.3%-6.5% from 5.5%-5.6% in 2012-13.

The government's next big agenda will be union budget 2013-14. It being the last full year budget of UPA II, the government will try to roll out a populist budget promising for more reforms. While the opposition may try its best to not let pass the UPA's any major announcement which can help it in the 2014 elections. Government will however try to launch a significant election campaign, which can be pictured by its macro and populist achievements in the later part of the year. Aiming to raise revenue without raising taxes, the government may try to kick-start the disinvestment programme early in the coming fiscal and for this government will even launch its PSU ETF in the next fiscal. The government will also try to push the pending bills in the parliament. The finance ministry already plans to introduce and hopes to pass the insurance and pension bills in the budget session of the parliament and is optimistic of getting support. The insurance bill proposes to raise the FDI cap to 49% from 26%, while the pension bill will open the sector for FII investment upto 49%. The much awaited Goods and Services Tax (GST), which is stuck due to differences between State and Centre over its structure and powers is expected to be in place this year and may be introduced in the monsoon session. The government plans to be on the path of meeting five year fiscal deficit reduction target (3% by 2017) without imposing tax burden.

The government will target to achieve 5.7% growth this year, rising to 6%-7% in the fiscal 2013-14 and will aim for 8% growth in 2014-15. The direct transfer of subsidy can be expected to help reduce leakage in the subsidy scheme and save on subsidy bill.

The RBI and finance ministry will have to work closely and deal with growth and inflationary conditions. While government may well plan its path to control its finances and meet its fiscal deficit target, the increase in non-subsidized fuel prices may continue to put inflationary pressure on the consumers and hence may continue to keep inflation at elevated levels (above the 6% comfort levels of RBI). We expect WPI inflation to average at around 6.5% in CY2013. The RBI will continue to face the challenge of controlling inflation and dealing with growth; and will closely monitor the inflation-growth dynamics and liquidity conditions before taking further rate cut decisions. Hence we may not see a big cut in policy rates by RBI, but we can expect gradual rate cuts leading to 75bps to 100bps cut in policy rate over the next 1 year.

Liquidity will continue to remain a concern in 2013. While RBI is expected to infuse some liquidity into system by bond buybacks through OMOs, the continued purchase of bonds can help further push bond yields downwards, as excess supply in the market will be absorbed by RBI thus providing some more room for traders to build positions before the expected cuts in policy rates in the coming months.

What is in store for debt market investors...

We have already seen most of the bond market rally happening in the past few weeks on expectation of rate cuts, and markets have already factored in a rate cut of 25bps to 50bps in the upcoming monetary policy meeting. Any further fall in yields (and rally in bond prices) would require more aggressive cuts in policy rates over the next few months, which seems unlikely given the conservative stance adopted by RBI so far. Budget being the next major event, the markets will expect the finance minister to guide the planned path towards fiscal consolidation and meet the fiscal and growth targets for 2013-14. Any spill leading to higher borrowing estimates and deficit may lead to a negative sentiment and bond yields may see a upside shoot of 25bps to 30bps. We can expect rate cut of 25bps to 50bps by March 2013 followed by another 50bps till December given the inflation stabilizing above the comfort level of RBI. If the inflation stabilizes around 6.5% levels and with the RBI providing some monetary stimulus to support growth, the bond yields may on an average trend in the range of 7.25% to 7.75% in CY 2013.

Hence we may not see a swift bond market rally as we witnessed in the recent past, but the conditions still looks lucrative to make decent gains in bond markets. Any intermediate rally will be short lived and hence one should not get carried away towards instruments having high interest rate sensitivity. The key will be to spread your bond portfolio across maturity. If you wish to play the interest rates, then you need to closely monitor the yield movement and take timely step to shift portfolio maturity.

We recommend investors not to speculate on a policy rate cut and would discourage them from taking very high exposure in long term G-secs and gilt funds with a sole purpose of betting on turnaround in interest rate cycle. With the lack of government spending's, markets may witness occasional tight liquidity conditions which may push yields on short term instruments and investors will see some opportunity building up even in their shorter maturity investments.

Citing these reasons, we believe betting on a particular end of the maturity curve would be risky, and hence you need to invest in a portfolio or a fund which can take exposure across maturity curve. A fund like dynamic bond fund or flexi debt fund may yet continue to do well with the fund manager having flexibility to shift maturity. One should not miss out the opportunity to lock their portfolio at higher rates based on their time horizon. Hence we recommend investors to consider their investment time horizon before deciding upon the category of debt instruments and debt mutual funds.

To read if Indian equities can continue to surprise you in 2013, please click here

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