We have favored long duration government bond exposures for more than a year now in our actively managed bond and gilt funds. This view was enabled by our assessment of structural tailwinds to India bonds led by revised current account dynamics and a credible fiscal and monetary policy framework. Policy developments since then have if anything reaffirmed that view, with the latest case in point being the continued fiscal consolidation in the just concluded Union Budget and the adoption of an institutionalized framework targeting debt to GDP from FY 27 onwards. Alongside, monetary policy remains credible and sporadic inflationary pressures are coming off. This should set up a clean runway for long duration bonds from a macro-economic standpoint.
However, long duration bonds have underperformed significantly over the past few months. As the chart below shows (source for all charts: RBI, Bandhan MF Research), there has been a significant rise in term spreads between 30 year and 10 year government bonds; especially over the past 3 months or so.
It is to be noted that the discussion here is on relative performance of the long end versus 10 year and not bond yields generally. Thus the upturn in US rates and re-acceleration in dollar strength since mid - September should not be the cause for the rise in these term spreads. Heightened global uncertainty leading to investors demanding more term spreads could be one explanation. However, the same should have been visible in term spread between 10 year and 5 year segments as well, which is not the case.
Instead, the obvious answer seems to be plain old-fashioned near term demand and supply for this segment specifically. We turn next to a detailed discussion on this.
Over the past few years there has been a sustained rise in average maturity of issuances, especially for the center but also for states.
This reflects prudent debt management to some extent (given larger upcoming maturities for the next several years) as well as matching supply to the rise in demand from long term investors.
However, the incremental ‘mandate-driven’ long end demand seems to have weakened as evident in recent flow information, anecdotal evidence, as well as the rise in term spreads as shown above. This in turn makes the case for re-examining the proportion of long term issuances going forward. A very strong additional reason for doing so is seen in the chart below.
As can be seen in the chart the period of high annual maturity runs till FY 35. From FY 36 onwards maturities begin declining again. Thus even from a risk management standpoint, the government can now afford to start bringing down the average maturity of borrowings.
The next question to ask is, why bother? The answer lies, in our view, in the same framework of ‘constraint optimisation’ that has lately been our anchor in thinking about macro policy.
Constraint Optimisation Again
The government has done a remarkable job of re-establishing fiscal credibility through measured and focused actions over the past few years. The recent Union Budget was yet another affirmation of this credibility. Associated with this, however, also have to be endeavors to optimise benefits from this credibility. One of the obvious ones is that so long as the government is confident about adhering to broad fiscal frameworks, it can afford to worry less about refinancing future debt maturities.
As we have shown above, even keeping refinancing conservatism in mind, the government can afford to bring down the average maturity of issuances going forward. That this is needed is brought out in the following chart:
Interest payment to GDP has risen appreciably over the post pandemic period. This has correspondingly cut fiscal flexibilities. While the major driver to bringing this down will be reducing debt to GDP (the framework for which the center has already presented), some small incremental gain can also be made from optimising cost of borrowing. Indeed, if the government were to behave like a private commercial issuer, then the confidence that macro policies are progressively aligning India towards a lower perceived risk destination should argue for lower propensity to lock away incremental long term borrowings at current rates.
Additionally, the 5 - 10 year segment will likely see robust demand over the next couple of years owing to rate cuts and possibly large OMOs from RBI (the latter to compensate for weaker balance of payment surplus, annual currency in circulation drain, and the need to ensure abundantly surplus liquidity to transmit upcoming rate cuts). Thus stepping up issuances in the vicinity of the 10 year segment also addresses upcoming demand, just as enhancing issuances at long end has done over the past few years.
Investor Standpoint
We conclude with reasons as to why we think the long end of the government bond curve, notwithstanding recent underperformance. still looks very good to us.
1. The underlying macro reason for owning long tenor bonds remains intact. Indeed, in looking for reasons to revisit the trade, our primary trigger would have been some re-think by the government on the fiscal framework. To be clear it wasn’t our base case view that it would, and we were happy to note that it didn’t. if anything then, there is reason to be more and not less confident with respect to the long duration trade.
2. The average tenor of issuance has been increased meaningfully over the past few years. This has been to cut roll over risks on large maturities lined up for the next few years as well as to respond to the strong rise in participation of the long term investor class. However, as we have shown above, the maturity ‘hump’ declines by FY 35, thereby allowing the government to start reducing average maturity of borrowings. This will also address some possible change in incremental demand pattern and will help optimise cost of borrowing as well.
3. Most importantly, real money investors shouldn’t necessarily worry about some widening of term spreads so long as yields are generally falling. This is basis the obvious point that the long end carries much higher duration and can deliver better absolute returns even with some widening of term spreads. Thus so long as the view on rates is bullish, it makes sense to own higher duration. Put another way, for fear of some curve steepening, investors may end up compromising severely on average duration which may hurt performance over the medium term.
The problem in the past few months has been that the rise in term spreads has been sharp over a short span of time, driven both by weaker incremental demand from long term investors as well as RBI largely buying 5 – 10 years under OMOs. Thus while yields in the mid duration segment have declined, the long end has remained largely stagnant. As this stagnation reverses, the duration benefit of the long end will reassert itself in performance even accounting for some further widening of term spreads. Additionally, if, as seems logical basis the reasoning presented above, government / RBI were to tweak some supply away from the long end, then the performance could be even more pronounced since then term spreads may have no reason to widen further. An additional trigger here could be the advent of public sector insurance into the bond forward market.
Finally, and most fundamentally, long duration government bonds still look to us as one of the best macro trades on India’s rising relevance on size, its macro-stability narrative, and the likely continued discovery of Indian bonds by offshore investors over the next few years. Given this, the demand-supply dynamics presented here as well as potential issuance offsets discussed above are meant more as a short term analysis and do not take away from the attractiveness of long duration over the medium term.
Source: RBI and Bandhan Internal Research
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