The bond story continues to run strongly. Locally, the budget gave final proof of policy continuity and commitment to fiscal consolidation. Globally, signs of slowdown have become more pervasive and, combined with better behaved inflation, is finally nudging the Fed as well to actively contemplate rate cuts. Meanwhile, China has executed fresh monetary easing and bond yields there seem to be in freefall despite the central bank supposedly actively wanting to put a floor to these yields. The yen has finally discovered a lease of life, strengthening rapidly over the past few days thereby putting paid to ‘carry’ trades around the world that have used the Japanese currency to fund exposures elsewhere. Apart from the weakness in China data, this may be partly responsible for putting downward pressure on commodity prices, even as concerns have risen again with respect to global freight rates.
In short, a strong structural story for India is coinciding with what looks like generally a global tailwind for bonds. As if this wasn’t enough, the proposed RBI tweaks to the liquidity coverage ratio (LCR) framework for banks, if implemented, will generate an additional large demand for SLR bonds. While bonds have rallied, particularly shorter-term ones where LCR related demand is likely to be higher, there still seems to be enough resistance from market participants to wholeheartedly embrace the market. More specifically, we have lately seen some resistance from real money entities to the idea of being overweight 30-year government bonds. The arguments seem to be around liquidity in the segment, a view that it is a ‘crowded’ trade, that the move here is overdone, and, most recently, that delisting incremental issues from FAR status will lead to loss of interest in this segment from global investors. Since this remains a high conviction trade for us, we offer some counterarguments here. As before, this is done respectfully and in the spirit that views contrary to ours are important for us to take on board and examine.
The long end of the curve is no longer an exotic area as it used to be till a few years back. As is well known and appreciated, long term investors like insurance and pension funds have rapidly gained prominence in the market. Reflecting this, 30 year and beyond now constitutes approximately 35% of annual central government bond issuances. To put things in perspective, 10-year issuance is under 25% of annual even as it remains the most liquid part of the curve in secondary market trades. However, and as a result of its increasing importance, liquidity at the longer end is no longer as constrained as it used to be in the past. Furthermore, this is probably the only segment where most of purchases happen against genuine future liabilities. Indeed, with rising prominence of investors in this segment, a reasonable large forward rate market has also developed which is being used by insurance companies to safeguard future payouts. Thus while ‘narrative noise’ here may be large, it is a stretch to call positions here as being overcrowded since most of these serve a genuine purpose in the business models of companies that are owning these securities.
The point on this being overdone also needs further scrutiny. Even if there is disagreement with our structural view on India bonds, there is little counter to a decently bullish view for the next couple of years or so. Duration matters for real money investors and the 30-year bond provides roughly twice of this as compared with the 10 year. Thus, even if the yield curve steepens somewhat as the rally progresses, the extent of such steepening has to be very meaningful for the 30 year to underperform 10 year on an absolute basis. The matter is different for trading outfits where face value of bonds held is not the constraint but risk limits are. But this is not the case for real money like mutual funds, insurance, pension, and such like.
Finally, the concern that incremental 14 and 30 year bonds not being FAR will lead to loss of interest here from FPIs also seems quite overblown. For one, there are adequate limits remaining in the general quota for FPIs to participate in non-Far securities as well. Indeed, FAR bonds so far have hardly commanded any premium to their non-FAR counterparts. Two, the outstanding stock of 30 year remains for FPIs to buy into, basis secondary market availability. If anything, the announcement makes these more valuable since you don’t have additional supply here.
Our view, of course, is that India bonds are structural and we fully expect the demand-supply equation to overwhelmingly start swinging in favor of demand overtime. The government’s focus on reducing debt to GDP further adds conviction to this view. With this in mind, we remain very comfortable with our overweight 30-year government bond view and suggest investors with the requisite risk appetite and investment horizon to also not get overly distracted by short term noises. The risk with the distraction is that of missing the forest for the trees, or standing too close to the painting and missing the bigger picture.
Source: RBI and Bandhan internal research
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