30 Sept 2014

RBI Policy Stance and Long Term Bond Funds – Will Investors Stand to Gain?

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The bond market can expect the RBI to maintain Repo Rate at 8% for the next one year or until CPI (Consumer Price Index) trends down to 6% from current levels of 7.80%.

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Arjun Parthasarathy

The bond market can expect the RBI to maintain Repo Rate at 8% for the next one year or until CPI (Consumer Price Index) trends down to 6% from current levels of 7.80%. The central bank is expected to keep SLR (Statutory Liquidity Ratio) at 22% of NDTL (Net Demand and Time Liabilities) even as the HTM (Held to Maturity) limit is cut from 24% of NDTL to 22% of NDTL over the next one year. 

What does RBI policy mean for bond yields going forward and for long term bond fund investors? Ten year government bond yield is at levels of 8.50% at present and if RBI is going to maintain status quo on Repo Rate at 8%, the scope for the ten year bond yield falling below 8% is not very high. Given that bond fund investors have to hold on to investments for 36 months to avail of long term capital gains tax benefits ( the enthusiasm to invest in bond funds may not be high.

Will ten year bond yield trend down below 8% and will long term bond fund investors gain by investing at current levels of yields on the ten year bond? The questions are best answered by understanding why the RBI is keen on maintaining rates status quo.

RBI is keen that India moves to a path of falling inflation expectations. The economy has suffered from high inflation with inflation as measured by the CPI averaging over 9% over the last five years. Inflation has hit value of the INR that is down 50% against the USD from levels seen in 2008. Economic growth has come off sharply from levels of over 8% to levels of below 5% over the last few years. Hence in order to achieve its objective on inflation, policy is on an inflation targeting mode.

RBI policy alone cannot lower inflation expectations. The government must play its part by cutting its fiscal deficit, which it is doing as it strives to meet its FRBM (Fiscal Responsibility and Budget Management) Act targets of 3% of GDP in fiscal 2016-17 from 4.1% of GDP budgeted for this fiscal. Government has also rationalised subsidies by achieving almost full pass through of oil prices to the end users of petrol and diesel. 

Food prices that have been extremely volatile and account for almost 60% of CPI inflation must also start behaving properly. Improved management of food stocks would result in food prices staying stable and the government is looking to do this by overhauling the FCI (Food Corporation of India).

Global commodity prices must also play its part in lowering inflation expectations. Fortunately, the outlook for commodities is negative given various factors such as US shale oil revolution, China slowdown and overall weakness in the global economy. 

The fact is RBI is being helped by the government and global markets in its effort to lower inflation expectations and that will play out positive for the bond markets over a period of time. Hence the direction of the ten year government bond yield is down, even though the time frame may be longer than expected. Bond fund investors with three year plus holding period horizon will benefit from the RBIs stance on inflation, as stable to lower long term inflation expectations is positive for bond yields.

It is an ideal time to invest in bonds/long term bond funds for investors who look forward to a period of falling inflation expectations.


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