An Eye on Debt Market in October 2023

The Government Securities (G-Secs) yields witnessed a sharp jump after the Monetary Policy Committee (MPC) meeting in early October 2023 as the Reserve Bank of India (RBI) governor announced the possibility of conducting Open Market Operation (OMO) sales to manage liquidity actively. 

After the run-up of 10-15 Basis Points (bps), the yield across the curve moved within a narrow range for the rest of the month, and 10-year G-Sec yields ended at 7.36%, up 14 bps compared to last month. 

Apart from those mentioned above, the movement in yields was driven by factors including elevated US yields, an outbreak of the Israel-Hamas conflict, a rise in oil prices, and strong Indian bank credit growth, among others. The corporate bond spreads narrowed compared to last month on lower supply. 

The Foreign Portfolio Investors (FPIs) bought (including voluntary retention route) debt worth US$ 0.8 billion in October 2023 (September 2023: US$ 0.1 billion). Cumulatively, FPIs have bought debt worth US$ 3.6 billion in 7MFY24 (7MFY23: US$ 0.01 billion).

The RBI minutes were largely in line with expectations with a balanced view on growth and inflation. Most members stated that growth momentum remains strong and inflation is under control except for occasional spikes due to volatile vegetable prices. The key risks highlighted included spillover from global capital markets, higher than target inflation (4%), and risk from food and energy prices, among others. 

Given the relatively hawkish communication of the RBI, highlighting the possibility of usage of OMO sales as an active tool for liquidity management, special emphasis on achieving its 4% inflation target on a durable basis, rising consensus on rates likely to remain ‘higher for longer’ in Advanced Economies (AEs), uncertainty for the Indian G-Sec market has increased in the near term.

However, from a medium-term perspective, analysts expect the debt market to likely be driven more by favourable rather than negative factors. 

The key drivers that bode well for the decline in yields over the medium term include: 

The robust tax collections and growth in small saving collections limit the risk of fiscal slippage and additional market borrowings. Moreover, the net supply of Statutory Liquidity Ratio (SLR) securities in H2FY24 is significantly low. 

The inclusion of India’s sovereign securities in the JP Morgan bond index can result in FPI flows of US$ 23-25 billion (16% of estimated net G-Sec supply for FY25), which bodes well for the demand outlook for G-Sec and can effectively cap any significant rise in yields.  

The Consumer Price Index (CPI) and core CPI are likely to trend lower in view of the correction in vegetable prices, decelerating core momentum, lower input price pressure, and benign global commodity prices. Inflation expectations also remain well anchored and are trending lower. 

The growth is likely to soften in view of the decline in fiscal impulse, slowing external sector, and moderation in private consumption. 

The RBI is expected to maintain an extended pause. The bar for restart of rate hikes by RBI remains high despite sharp rate hikes by the US as adequate foreign exchange reserves should keep pressure on the rupee at bay. 

However, there are counterbalancing factors that are likely to put upward pressure on yields, which include:

The timing and quantum uncertainty with respect to OMO sales by the RBI.

The growth continues to remain robust, and if sustained, there is a risk of core inflation reaccelerating. 

The headline CPI remain susceptible to elevated food price in view of the temporal and spatial distribution of monsoon and its impact on crop yields.

The 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. Therefore,  the incremental demand from key buyers of G-Secs (banks and the insurance sector) is likely to remain muted.

The continued global monetary tightening and risk of a rise in commodity prices, especially oil, are driven by China’s reopening and geopolitical dynamics.

The significant increase in global bond yields can have a rub-off effect on Indian yields as well.

On an overall basis, analysts are of the view that yields are likely to trade in a range in the near term, although they believe that the long end is likely to outperform over the medium term.  

While the analysts continue to recommend investments into short to medium-duration debt funds, given the sharp rise in yields in the past couple of months, investors could consider a higher allocation to longer-duration funds, in line with individual risk appetite.