An Eye on Debt Market in December 2023

The calendar year 2023 proved to be volatile for global fixed-income markets, particularly in Advanced Economies (AEs). Amidst synchronised tightening by major central banks worldwide, AEs witnessed significant swings in yields as both growth and inflation exceeded expectations. 

However, a cooling labour market and easing inflation in the United States, coupled with dismal growth in Europe and the US  Federal Reserve’s pivot in December, resulted in a sharp correction in yields. By the end of the year, 10-year Government Securities (G-Secs) yields in major countries either remained similar to or lower than the levels observed at the end of 2022. 

Conversely, Indian G-Secs yields traded within a narrow range. The long-end yields rallied, while short-end yields closed the year higher than the previous year. The announcement of in-line market borrowing in the budget and an unexpected pause by the Reserve Bank of India (RBI) in April 2023 led to falling yields in the first half. 

Furthermore, the announcement of the withdrawal of tax advantage for investors of debt mutual fund schemes and insurance policies from FY24 led to large inflows to these in March-end 2023.  These flows pushed the yields lower, too. 

However, elevated inflation, primarily driven by food prices, along with the draining of interbank liquidity by the RBI and the possibility of Open Market Operations (OMO) sales to manage liquidity, resulted in rising yields in the second half at the short end.

India’s inclusion in global bond indices and a correction in US yields in the last quarter prevented any significant rise in yields in the long run. The 10-year G-Secs yields concluded the year at 7.17%, 16 Basis Points (bps) lower. Corporate bond spreads widened compared to the previous year due to increased supply. 

The table below gives a summary view of the movement of key rates and liquidity: During the year, the average interbank liquidity experienced a significant decline, primarily influenced by an increase in currency in circulation and Cash Reserve Ratio (CRR), higher government balances, and OMO sales conducted by the RBI. This reduction in liquidity was partially mitigated by forex purchases carried out by the RBI. 

Foreign Portfolio Investors (FPIs), including those under the Voluntary Retention Route, made debt investments totalling US$ 7.4 billion in 2023, a  noteworthy shift from the previous year when there was a net sale of US$  1.6 billion in 2022. A substantial portion of these inflows, about  70%, occurred in the second half of 2023, especially following the announcement of the inclusion of G-Secs in JP  Morgan’s global bond indices. 

Credit markets remained largely stable throughout the year. Credit spreads, which had reached their low point in 2022, saw a modest increase in 2023 due to the expansion in corporate bond supply. However, these spreads remained below historical averages as demand from banks continued to be robust. 

Outlook  

In 2023, the Indian fixed-income markets demonstrated relative stability, particularly in contrast to the high volatility witnessed in the debt markets of the US and other advanced economies. This resilience can be attributed to several factors, including a low risk of fiscal slippage,  consistent demand from long-term buyers such as insurance and provident funds, easing core inflation, a correction in commodity prices,  and a comfortable external sector characterised by ample forex reserves and a manageable current account. 

The outlook for fixed income remains favourable over the medium term, given the following key drivers: 

• The inclusion of India’s sovereign securities in the JP Morgan bond index bodes well for the demand outlook for G-Sec the next year and can effectively cap any significant rise in yields.
• Core CPI momentum remains subdued on the back of lower input price pressure and benign global commodity prices. Inflation expectations also remain well anchored and are trending lower.
• The government is likely to continue on the path of gradual fiscal consolidation; thus, market borrowings are likely to remain manageable.
• The external sector is likely to be supported by steady services exports and adequate foreign exchange reserves.
• The rate hike cycle in AEs has ended, and expectations of rate cuts are high during the year. RBI is also likely to cut rates in the second half of 2024; however, we expect a shallow rate cut cycle.

However, there are counterbalancing factors that can put upward pressure on yields.

• Regular food price shocks can keep headline CPI elevated and can adversely impact inflation expectations.
• SLR holdings of the banking system are high, and credit growth is robust. Furthermore, the demand from the Insurance sector is likely to taper down vis-à-vis last year. As a result, incremental demand for G-Secs is expected to remain muted.
• Risk of rise in commodity prices, especially crude oil.

Overall, in our view, yields are likely to trade in a range soon, although experts think that the long end will likely outperform over the medium term. 

Given the expectations of a shallow rate cut cycle, experts continue to recommend investments into short to medium-duration debt funds. However, given the elevated yields in the long run, investors could consider a higher allocation to longer-duration funds after considering the individual risk appetite.