Tuesday's Talking Points
Dip in probability of further rate hikes - Time to accumulate Debt!
Over the last few days, the global capital market volatility has increased significantly on the back of closure of two medium sized banks in the US and fear of contagion risk spreading across the financial sector. The mix of bulky concentrated deposits, rise in yields, inappropriate Asset-Liability Management and lenient regulations resulted in select banks facing liquidity issues as the redemption of deposits accelerated. The contagion effect of the crisis was, however, contained by swift actions of US regulators. For the US Federal reserve, financial stability concerns could now take precedence over elevated inflation. Thus, market has turned sanguine about US Fed pausing or cutting rates sooner than earlier anticipated. This had a rub off effect on other economies including India as well and expectations of RBI pausing or being closer to end of rate hike cycle has also increased.
In India, the yield curve has seen significant ‘flattening’, with the difference between longer and shorter end of the yield curve reducing significantly in the past few months. As of March 14, 2023, the yield on a 1-year Government Security (G-Sec) stood at 7.38% versus 6.72% at the start of the year. The 10-year security, on the other hand, was at 7.37% versus 7.33% at the start of the year.
“Yield Curve” refers to the structure of rates across maturities. The short end of the curve refers to interest rates for bonds with shorter maturities (3 months – 1 year), and the longer end refers to higher maturities (10+ years).
Chart 1: Yield Curves on different dates – While CY22 saw the yield curve move upward, CY23 has seen ‘flattening of the curve’, with increases only at the shorter end
Chart 2: Global Central Banks are now expected to have minimal rate hikes going forward
Note: Implied rate hikes / cuts are computed using Fed Funds Futures rates.
Source: Bloomberg, As on March 14, 2023
Thus, attractiveness of debt investments has increased with higher yields on offer. In terms of duration, while yields are high and relatively flat across tenors, investors are likely to question the choice of allocating towards longer durations. If the one-year paper is yielding at similar levels as the ten-year paper, the benefit of investing in longer tenors is not apparent. What one may consider is the reinvestment risk, i.e. the risk that future investments could be at lower / higher interest rates, and therefore overall longer-term returns could be lower / higher.
Debt Market Outlook
Over the past few months, the Indian 10Y Gsec yield has moved within a narrow range despite significant volatility in global bond yields, rise in domestic policy rates and external sector risks. Majority of these factors have started to ease and consensus is that these are likely to continue moderating in the near term. Moreover, there is increasing consensus that major central banks, including US Fed and RBI, are nearing the peak of rate hiking cycle driven by significant tightening in 2022 and softening inflation and growth outlook.
Besides, the real policy rate on 1 year forward average CPI forecast (by RBI of 5.3%) is ~120 bps. The announced budgeted market borrowings for FY24 were in line with market expectations and alleviated concerns on Gsec supply. All the aforesaid factors are likely to bode well for the fixed income outlook.
Key risks to yields falling include elevated core CPI, resilient domestic growth, robust credit demand and continued global monetary tightening. Heightened geopolitical risks, elevated oil prices, tight liquidity and increase in state development loans (SDLs) are also other important factors which can keep the yields at elevated levels.
What could be a suitable investment option during such an Environment?
With the rise in attractiveness of yields across the board, an investor could consider accumulating debt in their portfolio mix. Additionally, despite the yield curve being flat, investors could consider adding longer dated debt in a staggered manner to lock in longer term yields.
Readers interested in knowing more could also register for the upcoming webinar on “Fixed Income Outlook: Time to accumulate”, where HDFC AMC’s Fixed Income Investment team shall provide their outlook on Fixed Income Markets. The webinar is scheduled to be held on March 15th 2023, 5:15pm IST onwards. Interested readers could register at https://bit.ly/timetoaccumulate
Sources: Bloomberg, Reserve Bank of India, and other publicly available information.
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