Tag: bond yield

Covid resurgence will force RBI to keep the monetary tap open, bond market shows, BFSI News, ET BFSI

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NEW DELHI: Central banks around the world sure have their work cut out. Just when monetary authorities were preparing the ground for a reversal of ultra-loose policies adopted in response to the coronavirus crisis, the virus, it seems, has taken new and potentially more dangerous avatars.

From bracing for interest rates in major economies to head northward sooner than later, global bond markets on Thursday took a 360-degree turn.

With a new and possibly even more deadly variant of the coronavirus being detected in South Africa, Botswana and Hong Kong, a fresh outbreak of the disease may well be on the cards. When this is coupled with a recent resurgence of Covid-19 in Europe — which has been accompanied by attendant restrictions on activity — the risk to global growth has intensified significantly.

The price action in global bond markets on Thursday showed this. Instead of getting ready for imminent policy normalisation, the bond markets seemed to be expressing the view that monetary accommodation would stay for a while longer. Yields on 10-year US Treasury papers nosedived a whopping 12 basis points on Thursday and were last at 1.51 per cent.

Clearly, investors are betting on the helping hand of central bank interventions to return.

THE INDIAN STORY
Indian sovereign bonds on Thursday enjoyed their best day in three-and-a-half weeks, with yield on the 10-year benchmark 6.10 per cent 2031 paper dropping four basis points.

Prior to the detection of the fresh variant in South Africa, a strong view in the market was that the Reserve Bank of India would start the process of raising interest rates at its next policy statement, on December 8, by raising the reverse repo rate and, therefore, narrowing the width of the liquidity adjustment facility corridor.

The central bank has already paved the way for the step as the quantum of funds withdrawn and the cutoff rates set at variable rate reverse repo operations has pushed rates on money market instruments closer to the repo rate of 4 per cent rather than the reverse repo rate of 3.35 per cent.

However, even as money markets may have aligned to the new expectation of the reverse repo rate, the act of raising it would itself have significant implications – namely that the ultra-loose accommodation is now well and truly going to be reversed. Because one would hardly expect the central bank to reverse its stance once it has officially started the process of lifting interest rates.

Now, however, market players are betting that there is a strong possibility that Governor Shaktikanta Das will keep all rates on hold and say that the central bank wishes to obtain more clarity on the global situation (and the spillovers for India) before raising any benchmark rates.

For India, another salutary impact of the new risk to global growth is a decline in international crude oil prices. Even as the government has reduced excise duty on petroleum products, the extent of the rise in oil prices over the last couple of months had emerged as a significant risk to domestic inflation, while worsening the outlook on the trade deficit.

Crude oil futures on the New York Mercantile Exchange slumped 3 per cent on Thursday, while Brent crude, the global benchmark, shed 2.2 per cent.

“The market’s view is changing; that is clearly perceptible from today’s move,” ICICI Securities Primary Dealership’s head of trading and executive vice-president Naveen Singh said. “There was almost a consensus that the reverse repo will be hiked, especially as market rates have aligned to a higher rate. But now there is a view that the RBI will maintain the status quo and wait for more details about whatever is happening in Africa and Europe. Because they cannot hike and then cut again if Covid were to worsen.”

While the yield on the 10-year benchmark bond may face hurdles when it comes to falling below the psychologically significant 6.30 per cent mark, for now, traders do not see it revisiting the 6.40 per cent mark, where it was hovering around a couple of weeks ago.

Hardening inflation can take a backseat for now, bond traders seem to be saying. The spotlight has once again squarely turned on protecting economic growth from what seems to be a hydra-like disease – two new heads sprout whenever one is severed.



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Bond yields and equities – it takes two to tango

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In recent months inflation expectations have been on the rise both in India and the developed markets and its impact has been felt on bond yields globally, central bank QE (quantitative easing) notwithstanding. Since then a new narrative has been taking hold amongst some market bulls. This new narrative is that the long-term correlation between bond yields and equities is positive, and hence is not a cause for alarm among equity investors. If expectations of better growth is driving inflation upwards and results in a rise in yields, then it reflects optimism on the economy and equities are likely to do well in such a scenario, is their argument. Is there data to support these claims? Is increase in bond yield actually good or bad for equities?

Inconsistent narratives

When movement of bond yields in any direction is used as a justification for equities to go up, then you must become circumspect. Since the launch of monetary stimulus last year globally by central banks and the crash in bond yields and deposit rates, the narrative that was used to justify a bull case for equities (which played out since the lows of March 2020) was that there is no alternative to equities. Hence, when bond yields actually start moving up as they have since early part of this year, an alternative for equities is actually emerging. So, market bulls have now shifted the narrative to why increase in bond yields this time is positive for equities as in their view bond yields are rising in anticipation of better economic growth. Well actually by this logic, last year bond yields fell in anticipation of a recession, so ideally it should have been negative for equities, right? Logic is the casualty when goal posts are changed.

Economic theory vs reality

Theoretically, increase in bond yields is negative for equities. This is for four reasons.

One, increase in yields will make borrowing costs more expensive and will negatively impact the profits of corporates and the savings of individuals who have taken debt.

Two, increase in bond yields is on expectations of inflation and inflation erodes the value of savings. Lower value of savings, implies lower purchasing power, which will affect demand for companies.

Three, increase in bond yields makes them relatively more attractive as an investment option; and four, higher yields reduce the value of the net present value of future expected earnings of companies. The NPV is used to discount estimates of future corporate profits to determine the fundamental value of a stock. The discounting rate increases when bond yields increase, and this lowers the NPV and the fundamental value of the stock.

What does reality and data indicate to us? Well, it depends on the period to which you restrict or expand the analysis (see table). For example if you restrict the analysis to the time when India had its best bull market and rising bond yields (2004-07), the correlation between the 10-year G-Sec yield and Nifty 50 (based on quarterly data from Bloomberg) was 0.78. However if you extend your horizon and compare for the 20 year period from beginning of 2001 till now, the correlation is negative 0.15. The correlation for the last 10 years is also negative 0.75.

In the table, we have taken 4 year periods since 2000 and analysed the correlation, on the assumption that investors have a 3-5 year horizon. The correlation is not strong across any time period except 2004-07 . It appears unlikely we will see the kind of economic boom of that period right now. That was one of the best periods in global economy since World War 2, driven by Chinese spending and US housing boom as compared to current growth driven by monetary and fiscal stimulus, the sustainability of which is in doubt in the absence of stimuli. This apart, Nifty 50 was trading at the lower end of its historical valuation range then versus at around its highest levels ever now. Inflationary pressures too are higher now. In this backdrop, the case for a strong positive correlation between equities and bond yields is weak.

What it means to you

What this implies is that the data is not conclusive and claims that bond yields and equities are positively correlated cannot be used as basis for investment decisions. At best, one can analyse sectors and stocks and invest in those that may have a clear path to better profitability when interest rates increase for specific reasons. For example, a company having a stronger balance sheet can gain market share versus debt-laden competitors; market leaders with good pricing power can gain even when inflation is on the rise.

A final point to ponder upon is whether a market rally that has been built on the premise that there is no alternative to equities in ultra-low interest rate environment, can make a transition without tantrums to a new paradigm of higher interest rates even if that is driven by optimism around growth. An increase in Fed expectations for the first interest rate increase a full two years from now, caused temporary sell-offs across equites, bonds and emerging market currencies, till comments from Fed Governor calmed the markets. These may be indications of how fragile markets are to US interest rates and yields.

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After five years of losses, PSBs reported net profits in FY21: ICRA

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Public sector banks (PSBs) reported net profits in FY21 after five consecutive years of losses, supported by windfall treasury gains, according to ICRA. However, gains are likely to be much lower in FY22, given limited headroom for further decline in bond yields.

The credit rating agency estimated that the 12 PSBs booked profits of ₹31,600 crore from this source, compared to the overall Profit Before Tax (PBT) of ₹45,900 crore in FY21.

Trading gains

Notably, the trading gains for PSBs in FY21 exceeded the capital infusion of ₹200 billion received from the Government of India (GoI).

Notwithstanding the profits reported by the public banks in FY21, the agency said the PBT of other PSBs (excluding State Bank of India/SBI) at ₹18,400 crore were lower than their trading gains (₹25,500 crore), reflecting the challenges posed by Covid-19 on the asset quality and profitability of the banks.

ICRA observed that higher gains were recorded by PSBs on the back of relatively higher statutory liquidity ration (SLR) holdings compared to private sector banks (PvSBs).

Public sector banks losing market share in loans to private sector rivals

“The onset of Covid-19 resulted in windfall gains for public (sector) banks with trading profits on their bond portfolios rising sharply after the steep cut in policy rates by the Reserve Bank of India (RBI) in March 2020,” said ICRA in a note. Bond yields declined sharply in FY21 amid policy rate cuts following the onset of Covid-19.

Repo rate

The repo rate and the reverse repo rate were cumulatively cut by 115 basis points (bps) and 155 bps, respectively, during March 2020 and May 2020 to 4.00 per cent and 3.35 per cent, respectively, by May 2020.

Anil Gupta, Vice President – Financial Sector Ratings, ICRA, said: “As the banks booked gains on their bond holdings, their fresh investments are closer to the market rates, thereby aligning the yield on their bond portfolios closer to the market rates.

“The yield on the investment book for the public banks declined to 6.18 per cent in Q4 (January-March) FY21 from 6.79 per cent in Q4 FY20.”

Public sector banks support for Covid-19 health infra gathers pace

While banks make windfall profits amid the declining yield scenario, they could face challenges in their bond portfolios in a rising interest rate regime, opined Gupta.

“While the RBI is unlikely to be in a rush to hike interest rates in the near term, banks would need to be mindful as treasury profits would be relatively muted in FY22,” he said.

Like PSBs, PvSBs saw an improvement in their trading profits to ₹18,400 crore in FY21 (₹14,700 crore in FY20), which was 21 per cent of their PBT in FY21 (28 per cent in FY20), the note said.

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What is meant by bond yield hardening

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A phone call between two friends leads to a conversation on rising bond yields and what it means to them

Karthik: You know, I have been experiencing frequency illusion.

Akhila: What are you talking about?

Karthik: I learnt what yield means from last week’s Simply Put column in BusinessLine and now I see that word everywhere in all newspaper headlines.

Akhila: That the bond yields are hardening?

Karthik: Yeah. Any idea what yield hardening means?

Akhila: Hardening means rise in value. Yield hardening means bond yields are rising, which indicates that bond prices are falling. In the current context, this is with reference to the 10-year G-sec (or government bond), the yield on which has gone up from 5.9 per cent towards the end of January 2021 to about 6.2 per cent now.

Karthik: Since the yield is calculated by dividing the coupon rate with the current market price, any drop in the bond prices will raise the yields. I understand that. But tell me why are bond prices falling in the market?

Akhila: That is due to the government’s announcement in the budget that it will borrow an additional Rs 80,000 crore in February and March 2021 and a massive Rs 12 lakh crore in FY22.

Karthik: What is the link between bond prices and government borrowing?

Akhila: When the government borrowing increases, the supply of government bonds in the market increase. With concerns of oversupply of government paper in the bond market, there has been pressure on bond prices.

Karthik: Ok..

Akhila: As the yields on G-secs harden, the cost of borrowing not just for the government but also for companies inches up. Companies’ borrowing costs too are linked to G-sec yields.

Karthik: Oh! Can the RBI do something about it?

Akhila: RBI has been buying government bonds via open market operations (OMO) to keep the bond yield under check to control the borrowing cost of the centre. One section of the bond market watchers also argue that the central bank should stay away from any intervention as the rise in bond yields now is being witnessed globally and not exceptional to India.

Karthik: Oh! I get it now. I only hope that my existing fixed-income investments will not be impacted by these rising yields at this point.

Akhila: If you have any investments in the debt funds, they will.

Karthik: Oops. How?

Akhila: Due to the fall in bond prices, the debt funds you invested in may suffer mark-to-market losses on their g-sec or corporate bond holdings.

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