Lok Sabha elections handing the National Democratic Alliance (NDA) a slimmer majority than expected, has implications not just for stocks but for bonds too. Vidya has already written on the post-election investment strategy for equity investors in this report.
Here we discuss how the election verdict is likely to impact the bond markets and what strategies investors can use in light of this impact.
Our G-Sec calls
For the last couple of years, whenever the 10-year g-sec (government security) yield has approached 7.3% or 7.4%, we have recommended that investors lock into 4 to 5-year fixed deposits from banks and NBFCs and bet on debt funds that hold long duration g-secs (government securities) – such as gilt funds and 10-year constant maturity gilt funds. These recommendations were based on the view that India’s market interest rates, especially on long-term bonds, have already peaked and are likely to decline from here. Read our Debt outlook for 2024.
Though the election result has created some uncertainties around the timing of that decline, we see no reason to change the basic view on the direction of rates. Here’s why.
Deficit worries
In India, the government is the biggest borrower in the bond market. Therefore, the likely supply of g-secs is a key decider of how interest rates behave. In the past year, Central government actions on fiscal deficit have been very bullish for bonds. The February budget pegged the revised estimates of fiscal deficit at 5.8% for FY24, lower than the 5.9% expected earlier. It also projected that the Centre would target a sharp narrowing of the deficit to 5.1% in FY25 and 4.5% by FY26. More details in this earlier article.
This was positive for long term g-secs because it indicated that Central government borrowings (which had shot through the roof during Covid-19) would flatline at under Rs 12 lakh crore for FY25. Data released on June 1, 2024 has showed that the Centre has managed to do even better. It has managed to contain its fiscal deficit actuals to 5.6% of GDP for FY24. The absolute fiscal deficit number of Rs 16.5 lakh crore has turned out lower than the Rs 17.3 lakh crore forecast in the Budget. In effect therefore, the Centre has borrowed less than it projected in FY24.
Now, if the BJP had returned to the Centre with a sufficient majority of its own, this data would have set off a rally in g-secs (and a sharp fall in their yield). But the 10-year g-sec yield has actually seen a small spike from its recent low of 6.95% to 7.02% on June 11, the day when the election results were out.
The main reason for this is the market’s apprehension that NDA 3.0, which needs the support of two regional parties (Chandrababu Naidu’s TDP and Nitish Kumar’s JDU) to form the new government, will backslide on its deficit reduction targets.
The first fear is that NDA’s new allies will make populist demands that will force it to let go of its tight rein on Central spending. As things stand, the main demands from TDP and JDU seem to revolve around cabinet berths for party colleagues, Special Category Status for AP and Bihar, Central funding of state projects (such as Polavaram and Amaravati), scrapping the Agniveer scheme for defence recruitments, more farmer focus and so on.
The BJP high command has not ceded the key Cabinet position on Finance to its allies. Therefore, the risk of a new Finance Minister who will deviate materially from NDA’s long-standing policy on fiscal deficit reduction, is now off the table. With respect to other demands, the BJP could concede special status to the two States. But this would mean a higher devolution of Central funds to these two States (probably at the expense of other States), without material implications for the deficit.
A second apprehension is that the BJP itself may take a more populist turn in its upcoming budget to spend more on farmers, rural poor, women, minorities etc – all of whom seem have expressed their disenchantment with the BJP through their votes. This pivot looks likely, especially with the new Government kicking off its term with PM Kisan transfers and a revival of the PM Awas Yojana to construct 3 crore homes for the poor.
However, this would be a material risk to bond prices only if the government abandons fiscal consolidation and lets its fiscal deficit overshoot 5.1% this year. This looks unlikely right now for a few reasons:
- One, as its heads into the FY25 budget, the Centre has already been gifted an unexpectedly large dividend cheque of Rs 2.11 lakh crore from the RBI, which is at more than twice the budgeted amount. This gives the government additional headroom of Rs 1.25 lakh crore to spend on welfare in FY25, without upsetting its deficit calculations.
- Two, one of the key routes to belt-tightening adopted by NDA 2.0 was reducing revenue expenditure (salaries, subsidies, spending on schemes like MGNREGA), to expand capital spending to over 20% of the budget. If the rural poor, farmers and consumers turn priorities from here on, NDA 3.0 could re-allocate funds from capital to revenue spending. This won’t be great for the capex story, but will allow populism without impacting the deficit math.
- Three, India’s GDP numbers have been springing surprises over the last four quarters, with the WPI also beginning to rise. This is positive for nominal GDP growth in FY25, which makes up the denominator of the fiscal deficit ratio. If India’s nominal GDP surpasses the budget estimate of 10.5%, that will allow added elbowroom on deficit.
Having said this, until there is clarity on which route NDA 3.0 is going to take (which will be clear only in the July budget), bond markets may continue to fret about the fisc. 10-year yields and yields on long duration bonds may thus record two-way moves until then.
Foreign flows
The deficit apart, there were two other triggers adding to the bull case for Indian g-secs. These have not materially changed. One was the addition of Indian g-secs to the JP Morgan GBI-EM index with effect from this month, starting with weights of 1% and going up to 10% by March 2025. This move was expected to induce more FPIs to invest in Indian g-secs.
NSDL data shows that FPIs were already positioning for this move in the first five months of 2024, with $8.2 billion in flows so far this calendar year. While active FPIs may wait for clarity on the deficit etc before taking a big India bet, passive funds (estimated at $20-30 billion) will simply follow index weights and add to their India g-sec exposure.
A second trigger is that India’s fiscal situation is looking quite good in comparison to most developed as well as emerging nations, where governments have run up unsustainable levels of debt and deficits during and post-Covid. India’s improving fiscal parameters in fact prompted a reluctant S&P to upgrade its outlook on India’s sovereign rating (BBB minus) recently. This upgrade may draw global attention to the fact that a yield of 7% plus from a nation that has never defaulted on external debt, in its 77-year history, is a good investment proposition.
These two factors continue to support a moderation in yields on long-term g-secs even if the near-term uncertainties on deficit create a bit of a speedbump. The yield on the 10-year g-sec has remained quite rangebound in recent times. Between January 2024 and now, the yield has softened a bit from 7.18% to 7.02% (June 11) oscillating between 6.95% and 7.22% in this period.
At this point, we recommend the following for investors with 5-year plus investment horizon looking for debt options:
- Continue SIPs in gilt funds with high duration and 10-year constant maturity funds.
- Wait for greater clarity on Central finances from the budget, before making lumpsum investments.
Short-term investors
While the direction of long-term interest rates is influenced more by government borrowings, the direction of short-term rates hinges more on RBI policy on rates and liquidity.
Having hiked the repo rate by over 250 basis points between April 2022 and March 2023, the Monetary Policy Committee (MPC) has been on hold for about 15 months. Having moved to a “withdrawal of accommodation” stance to mop up Covid-related excess liquidity a while ago, it has not relaxed this stance either. The tight market liquidity brought on by this hawkish stance, amid the scramble for liquidity from banks, lending institutions and corporates, has kept short-term interest rates at elevated levels for the last six months.
Current market yields in fact show a flat yield curve, with 1-year g-secs trading at the same yield as 10-year ones, and 3-year AAA corporate bonds offering higher yields than 10-year ones.
It is unusual for short-term rates to trade above long-term rates in India. Therefore, this anomaly is bound to eventually correct. We think this will play out through a fall in short-term interest rates. A fall in short-term interest rates can only materialise if RBI relaxes its stance on liquidity.
Though it has been expected for some time that MPC will move from a ‘withdrawal of accommodation’ to a neutral stance, it has not been very accommodating on this score in its recent MPC meetings. The June 7 meeting was no different, with MPC remaining on pause on both repo rate and liquidity, despite two of its six members dissenting.
This is because RBI is keen to use tight liquidity to rein in hoarding and speculation in food crops, which stokes inflation. Chances are that the MPC will wait for clarity on trends in inflation in the upcoming months to consider a reversal on liquidity.
With 2023 monsoon proving truant and the post-monsoon season characterised by depleting reservoir storage, the rabi season for 2024 has seen food crop prices continuing to pop. The upcoming South-West monsoon promises to bring succour, with a fading El Nino and incipient La Nina. RBI may wait for conclusive data on the Kharif 2025 crop and monsoon performance before relaxing its stance on liquidity. As of now, this looks likely in the August (6-8) MPC meeting. A move to a neutral stance on liquidity may precede a rate cut, which can be pushed to the end of this year or early next year.
This could offer a relatively short window of opportunity for investors in short-term debt categories to enjoy high yields. Once liquidity eases, they will find that reinvesting will entail accepting lower yields. Here’s what you can do at this point:
- Those with a less than 1 year horizon can stick to the low duration, liquid and floating rate funds in Prime Funds
- Those with slightly longer horizons of 1 to 5 years must explore PSU and Banking debt funds and Short Term Debt funds in the same recommended list, to lock into the high spreads on corporate and bank bonds.
- For regular income seekers, this remains a good time to lock into 4-5 year deposits from our Prime Deposits recommendations.
