The benchmark 10 year government bond is the worst performing asset in calendar year 2017. The bond yield has risen by 100bps over the year and has given negative returns. In contrast, Sensex & Nifty have gained by around 30% each while the INR has appreciated by over 6%. Gold has gained by 7%.
The reasons for the 10 year government bond yield rising include RBI changing its stance from accommodative to neutral, government overshooting its deficit targets, rise in inflation expectations and Fed hiking rates.
How will the 10 year benchmark government bond perform in 2018. Will it continue its weak trend or will it reverse and start to perform?
We are putting out our fixed income strategy note for 2018 in the 1st week of January 2018, where we will elaborate on the future direction of yields. The bond market is going into 2018 on a weak note, with losses in 2017 leading to low risk appetite amongst investors and traders. The market is also staring at an additional Rs 500 billion of government bond supply and a budget for fiscal 2018-19 that could see the government resort to more borrowing to fund its road and rural infrastructure programs. Rising global bond yields on the back of Fed rate hikes is also preying on the market’s mind.
Immediately going into 2018, for the first couple of months the outlook for the 10 year government bond is not positive. Once the markets settle down with all negatives factored into yields, the markets may take a closer look at fundamentals.
Given that the bond yield has backed up by 100bps, another sharp rise in yields this year looks unlikely. India’s macro fundamentals do not warrant a too sharp rise in yields. Fx reserves are at record highs, CAD is still below 2% of GDP, fiscal deficit is at the lower end of the spectrum and liquidity is ample. The bond yield may just hover at current levels, give or take 25bps for the year, though there would be sharp rise or drops depending on various news and data inflows.
The 10 year benchmark government bond, the 6.79% 2027 bond, saw yields rise by 5bps week on week to close at levels of 7.32%. The on the run bond, the 6.79% 2029 bond saw yields close 4bp up at 7.16% levels and the 6.68% 2031 bond saw yields close up by 7bps at 7.21%. The long bond, the 7.06% 2046 bond saw yields close up by 9bps at levels of 7.42%. Gsec yields would stay at higher levels on higher government borrowing for this fiscal year.
The OIS market saw 5 year OIS yields closing 2bps higher week on week at levels of 6.75%. The one year OIS yield closed down by 2bps at 6.44%. OIS yield curve will steepen on the back of Fed rate hikes and bond market worries.
Corporate bonds saw 5 year AAA corporate bond yields close up by 7bps at levels of 7.74% and 10 year AAA corporate bond yields close up by 4bps at 7.90%. 5 year AAA spreads rose by 1bps at 50bps and 10 year AAA spreads rose by 1bps at 45bps. Corporate bond yields will be sticky on the back of high system liquidity and spreads will move on movements in government bond yields.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facility (MSF or Marginal Standing Facility) and MSS/CMB bond issuance was in surplus of Rs 761 billion as of 29th December 2017. The surplus was Rs 673 billion as of 22nd December. Advance tax outflows have brought down system liquidity from levels of over Rs 2000 billion and liquidity will rise on the back of government spending.