Shape Of The Yield Curve : A Bond And Macro Discussion

Let’s start with the obvious: price is determined by demand vs supply. In the case of bonds, yields will fall when the balance is in favor of demand and vice-versa. Yield curve inversions imply that instead of asking for higher yields when deploying for longer, investors are happy to accept lower yields presumably because they don’t expect the current levels of short term yields to last. This is why such curve shapes demonstrate market expectations of an impending economic slowdown and hence central bank action that will lead yields lower. It is also hypothesized in the Indian context many times as to what the shape of the curve may be implying. Most recently, if memory serves us right, the RBI Governor attributed flatter long term yields to well behaved inflation expectations.  We agree, and more on this below.

The core of our current investment hypothesis is that India is in the midst of a macro-economic transformation that is already cutting risk perception on our assets and will continue to do so progressively. We have written about this extensively in previous communications and the same is reflected in our portfolio strategies. Briefly, this view is built on current account dynamics, a matured inflation targeting monetary policy regime accompanied with proactive supply side management by the government, and the ongoing process of fiscal consolidation. This is especially notable in a global context given India’s large size and growing economy and market, particularly when offshore investors are anyway more interested now with impending bond index inclusion.

Given the above backdrop, how should investors look at the shape of the yield curve? More specifically, should the flat yield curve (or the absence of any notable additional compensation for owning higher duration) be a bother? In our view, no. If our hypothesis as summarized above rings true then it is perfectly logical to ‘lock away’ for higher periods the yields on offer today, rather than ‘settle’ for similar yields for shorter periods. This is because there is a real risk of reinvestment yields being meaningfully lower when current investments mature. In fact as conviction builds on this, and to the extent the collective of the market perceives reinvestment risk at future dates, one shouldn’t be surprised with some inversions starting to occur in duration segments of the yield curve (say 10 year to 30 year). Notably, this is already happening for SDLs where long end SDLs are getting bid at similar or lower than their 10 year counterparts. Importantly such inversions, should they occur, will be a sign of our perceived macro-economic strength and not weakness. To be sure there are seasonal demand – supply considerations at play here as well. However, the underlying point holds, in our view.

A more ‘real world’ way of looking at the evolving shape of the curve is to track how the relative importance of various investor classes is changing in the government bond market. The chart below shows this:


As can be seen, the share of long term investors has been progressively rising over the past few years. It is to be noted also that actual share may be even  higher given significant derivative ownership with such investors where the underlying bond may be held with another market counterparty. This provides context to the strong appetite for long duration bonds and the relative flat yield curve.

To clarify, one understands that investors have varying mandates, investment horizons, and risk appetites. This is certainly not a call to action for everyone to start owning long maturity bonds. Rather, we want to make two specific points: One, for investors who have the mandate, the flat curve shouldn’t come in the way of owing long duration bonds. The approach now has to be participative rather than tactical in our very strong view. We say this because we hear a lot of duration calls being anchored to expected rate cuts, just as they have always been in the past. This ignores the transformation underway. Two, and more broadly, within one’s allowed mandate one has to start taking the prospect of reinvestment risk much more seriously. Thus, as an example, one shouldn’t be too distracted with carry on offer currently if the duration of the investment (time to maturity or next reset of coupon) is short enough to expose one to future reinvestment risks even within the allowed respective investment mandates.

On our part, we are implementing this in two ways: One, in our active duration funds we continue to be overweight 30 year government bonds (> 80% as on date). Two, we increasingly find tactical roll down strategies as being less persuasive given that they expose investors to natural reinvestment risk, and are accordingly making suitable changes.



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