Bond is a fixed
income investment in which an investor lends money to the borrower (Issuer of
Bond) typically corporate or government for a definite period of time at a
fixed or variable interest rate.

One of the
key factors that impact bond prices is interest rate movements in the economy.
As the interest rate rises, the bond prices fall because new investors get
inclined to new bonds yielding higher rate of interest. This reduces the
attractiveness of the existing older bonds and hence their prices decline. Thus
bond prices and interest rates have an inverse relationship. It is pertinent to
mention here that longer duration bonds are more sensitive to interest rate
changes than shorter duration bonds, as shorter duration bonds offer shorter
volatility in returns.

Bonds market
in India has put up a somewhat average performance in 2017 after an upbeat run
in 2016. The 10 year G-Sec had a 1.2% fall in 2016 and notched up by 80bps in
2017. The only rate cut by RBI (only 25bps in August 2017) in 2017 as per
market expectation also did not help the bond market. Moody’s upgrade of
India’s sovereign bond rating and RBI cancelling the Open Market Operation
(OMO) also did not help much to ease bond market.

Rising
inflationary trends, concerns over rising global oil prices, tightening of
global liquidity, worries over India’s fiscal slippages etc. had an impact on
the bond market in India. After a 16 to 17% gain in 2016, the long term gilt
edged bonds funds only gained about 5 to 6% in 2017.

Major factors
impacting on bond market in 2018 are:

1.     Inflationary
Trends

2.     Fiscal
Policy

3.     Demand
Supply Scenarios of Government Bonds and

4.     Liquidity

 

 

 

Over two
years back, since RBI has put in a monetary framework that focuses on inflation
targeting, policy actions are mainly driven by movement in CPI inflation. CPI inflation
in July-August 2017 had come to a low of 1.5- 2% largely because of a sharp
decline in food prices. But in August, RBI had cut its policy rates by 25 basis
points to 6% and since then there was no change in the policy rates. Since
August, CPI inflation has been creeping up in past two to three months and RBI
has also increased its forecast for CPI Inflation from 3.5-4.5% earlier to
4.2-4.6% in October policy and to 4.3-4.7% in the December policy. RBI expects
increase in CPI inflation mainly due to increase in crude oil prices and HRA
increase under the Seventh Pay Commission. The recent increase in CPI Inflation
from 3.58% in October to 4.88% in November has been led by increase in food
prices- specifically vegetable prices. Also core Inflation (excluding food and
fuel) remains at a higher side at 4.9%. Given that RBI has a rigid medium term
inflation targeting at 4% without utilizing +/- 2% buffer, it’s highly unlikely
RBI will cut policy rates in near future. This probably may not enthuse the bond
market in India.

Several risks
to Centre’s fiscal deficit target has emerged during the year. Initially, government’s
fiscal deficit target at 3.2% in the 2017-18 annual budget did not please bond market.
In November, Government fiscal deficit target has breached to 112% of the budget
estimate of for 2017-18 mainly due to lower revenue generated from GST
collection and higher government expenditure. According to CAG data, the
difference in government revenue and expenditure was about Rs.6.12 Lakh during
April-November 2017 period. The government may borrow an additional Rs.50,000
Cr. in this financial year raising concerns that Government may miss its fiscal
deficit target. Bond markets may not be enthused to see centre straying from
its fiscal deficit target. Several states announcing firm debt waiver also puts
fiscal burden on states. Rising state deficit and debt may also have an inflationary impact in short term duration.
Therefore, fiscal slippages of both centre and states will have major impact on
bond markets.

One of the
key factors impacting bond markets is the demand and supply of government bonds.
RBI issues government on behalf of government under Open Market Operation
(OMO).  Demand from domestic as well as
foreign investors is a key factor impacting bond market in India. On domestic
front, Public Sector Banks have been flushed with liquidity post demonetisation
are net buyers of government bonds of about Rs.31,000 Cr between January and
November 2017. Mutual funds also have been net buyers of government bonds to
the tune of Rs.1,38,000Cr so far put in Rs.1.48lakhs crore in bond market in 2017. Overseas investors have shown greater demand for loan
owing to a stable rupee and lower real rate of interest. As per National
Security Depository Limited (NSDL) data, Foreign Portfolio Investors (FPI) have
utilized their investment limit in Government bonds up to 99.2% of their limits
as on December 11, 2017. The 10 year Government of India bonds offers 7.2%
today. After taking into account, a medium term inflation of 4.2%, the real rate
comes down to 3%. This is to be noted 10 year Guilt Bond offers 2.3%. Also rupee
has been one of the better performing currencies in Asia in 2017 and it is likely
to remain more or less stable in 2018 as well.

On
liquidity front, banks have been flushed with funds post demonetization which
gives them a comfort zone to borrow from Bond market. Alternatively, banks can
lend the excess fund to RBI under Reverse REPO. Globally, US Tax Bill may have
an impact on our Bond Market. A lower US Tax Bill allows companies to
repatriate funds from our market to US at lower cost. This may absorb some
liquidity from the market. Demand Supply dynamics in India are unlikely to turn
that unfavorable in 2018, which are good sign for India’s Bond Market.

To
conclude, some positives India’s Bond Market may be higher real rate on bonds,
stable rupee and RBI ensuring adequate liquidity through Open Market Operation,
Forex Interventions. However, fiscal slippages of centre and states, higher expected
inflation and higher than expected rate in growth may harden the bond yields in
coming months of 2018.