Prime Debt outlook 2022 – Interesting times ahead for debt investors

After sliding sharply and steadily in the seven years from 2013 to 2020, India’s interest rate cycle decisively reversed gears in 2021. CPI inflation stayed steadily above 5%, global inflation pressures picking up on supply chain disruptions and the US Fed and other developed world central banks biting the bullet on taper – all these factors worked together to apply upward pressure on India’s interest rates. 

The RBI and MPC did not respond to all these cues by hiking the key policy repo rate. But markets stole a march on them by moving ahead. The period between January 2021 and 2022 has therefore seen a strange situation where the official repo rate did not budge, but market interest rates across tenures moved up materially. In our debt market outlook written last January, we fully expected rate hikes to begin from H2 FY22. Though policy rates didn’t stick to this script, market interest rates did, helping our calls work.

So what’s ahead for 2022? Do we expect rates to now sidle sideways or to continue their climb? 

Though the onset of Omicron may see the MPC continue to make dovish noises and delay repo rate hikes as much as it can, we think that market interest rates will continue to climb in 2022 irrespective of whether or not MPC acts. We see three factors propelling them.

#1 Divergence in RBI’s actions

Though the MPC and RBI continue to describe inflation as 'transitory’ and promise an ‘accommodative’ stance in their policy reviews, there has been a visible divergence between what RBI has been saying and what it has been doing. The stoppage of the G-SAP programme and the wind-down of special liquidity windows have already shut off these taps of liquidity. After its latest policy review, RBI has also raised the amounts it mops up from its 14-day and 28-day Variable Rate Reverse Repo auctions (VRRR) auctions from Rs 6 lakh crore to Rs 7.5 lakh crore. 

These mop-ups will sponge up quite a bit of the Rs 11-odd lakh crore of systemic liquidity available with banks and non-banks. As the excess liquidity that has been available on tap to the bond markets dries up, call money rates, overnight rates and other short-term rates can be expected to move up significantly. Corporates which have been borrowing ultra-cheap from the CP market should expect to pay higher rates for their borrowings.

#2 Global rate changes

Though both RBI and MPC may continue to treat inflation as ‘transitory’ and cite the Omicron threat to put off rate hikes in their immediately upcoming policy reviews, pressure is likely to mount on them to lift repo rates from their record lows sooner than later. With the US Fed recently ditching its view that inflation is transitory and accelerating its liquidity withdrawal (taper), the Fed Funds Rate is now expected to see three hikes this year itself ending 2022 at 0.75-1% with three more hikes expected in 2023 to 1.5-1.75%. Yes, this dot plot could keep changing through the year causing two way moves in global rates. 

But for emerging markets like India, narrowing rate differentials with the US inevitably lead to pullouts by FPI. India’s bond market in recent years has attracted more short term FPIs than its equity markets. Recent signs of a weakening Rupee taken with the prospect of narrowing rate differentials will likely trigger FPI pullouts from Indian bonds in 2022.

This can again fuel a rate rise as domestic bonds see more sellers than buyers. RBI and MPC, though they may not overtly say it, will find it harder to ignore risks to Rupee and may find it necessary to hike rates to stem such pullouts. This can take up market yields in the mid-term corporate bond and g-sec segment of the bond market.

#3 Central borrowings

Longer tenor g-sec yields like the 10-year are highly influenced by the size of Central government borrowings. The Centre did manage to keep a remarkably tight lid on its borrowings in the first half of FY22, leading to the belief that the fiscal deficit would be contained within the 6.8 per cent target. But pressures are now building up for an overshoot, thanks to recent demands for grants, uncertainty over disinvestment receipts and the Omicron scare which may again depress tax revenues. This has forced RBI to allow the 10-year benchmark yield to move up from 5.8% to 6.5% through 2021. 2022 may see the yield move up further.

G-secs: Expect uneven up moves

While there’s a good case for market interest rates across tenures to move up in 2022, we think that the increases are likely to be uneven across tenures. 

• Below 1-year g-secs/corporate paper are likely to see the highest rate spikes, given that they have only seen yields move up 50-60 basis points in 2021. There could be an 80-90 basis point up move left here. This move appears more predictable than the one in long-tenor bonds.  
• The 3 to 5-year segment which has already seen yields spike sharply to close the gap with the 10 year, is unlikely to see very sharp increases. 
• The 7 to 10-year segment may again see yields move up 40-50 basis points by year-end, but these targets could be hit after considerable volatility triggered by global rate actions, speculation over the Centre’s borrowing programme and FPI pullouts.   

This makes it a dicey proposition to buy into long-term gilt funds or long-term g-secs or SDLs with a fixed rate over the next few months as the probability of capital losses (if you exit before maturity) will be high.

Corporate bonds: Quality loses sheen

With government bond yields rising, corporate bonds followed suit. But with corporate borrowers not very interested in investing in capex or tapping the markets for long-tenure bonds, issuances in the market were tepid and came mainly from top-notch borrowers trying to cash in on record-low interest rates. Most bond buyers seeking safety amid Covid helped these high-quality corporate borrowers borrow at bargain-basement rates both in the commercial paper and short-term corporate bonds. 

It is these factors which led to corporate bond spreads for top-rated borrowers shrinking to record lows. Corporate bond spreads capture the extra returns that riskier corporate bonds earn over g-secs. AAA spreads, which were already not great in early 2021 narrowed further by January 2022 to 40-45 basis points.

And with bond buyers exhausting AAAs and finding the yields lukewarm, buyer interest moved to AA+ bonds, narrowing those spreads from over 120 basis points to only 90 basis points too. A look-back at history shows that AAA bonds traded at spreads of 100-120 basis points over g-secs and AA+ bonds at 130-150 basis points as recently as end-2019. 

Given that we expect 2022 to bring a gradual return to economic growth and normalcy in capex activity (we don’t expect the Omicron surge to last beyond March), bond yields for AAA and AA+ are quite likely to move in the opposite direction from other securities, to rise in 2022. Owning high-quality bonds may therefore come at the expense of very poor returns (low yield plus the possibility of capital losses from rate risk). 

Our prediction for a recovering economy, improving corporate earnings and reviving capex however make a case for investing in bonds rated below the top two rungs – AAA and AA+ - as spreads in these segments are still reasonably attractive. Corporates apart, the surprisingly strong state of bank balance sheets (noted by RBI’s recent FSR and Trends and Progress of Banking reports), may also make a case for buying into Tier 2 and perpetual bonds from the better banks if they offer good spreads.

Recommended strategy

The above reasoning leads us to suggest the following strategy for fixed income investors in the year ahead. 

1. 2022 will remain a year of high interest rate risk, so it will be best for investors to stay off both gilts and corporate bonds of above 5-year tenure (especially for goals less than 3 years away), at least in the first half of the year as rates climb.
2. Given our expectation of a sharp rise in rates, we think investors will be offered opportunities to earn much higher yields from g-secs and safe issuers from mid-2022. We will come up with such gilt calls when the opportunities arise. It would be prudent to park your excess cash, debt allocations in very short tenor instruments such as liquid funds, ultra-short funds and low duration funds for the next 3-6 months to make the most of these opportunities. 
3. As credit offtake picks up especially for small finance banks and NBFCs, they may offer higher interest rates to woo CASA. The new deposit insurance limit of Rs 5 lakh for bank deposits has made bank deposits safer too. Watch out for short tenor deposits offering better deals than mutual funds for less than 1-year buckets. We will be flagging such opportunities in Prime Deposits. 
4. Floating rate bonds remain a good option to beat rising rates. You can do this through GOI Floating Rate Savings Bonds, floating rate debt funds or the government of India’s floating rate bond (FRB) auctions which we will be covering more actively. 
5. Small savings schemes have not lowered their rates in tandem with the falling rate cycle. But now, these rates are unlikely to move up with market rates, as the government tries to economise on borrowing costs. Don’t lock into beyond 1-year small savings schemes right now.   
6. The risk-reward for taking on credit calls may improve in the year ahead. This may make a case for diversifying from debt funds playing on high-quality bonds, PSUs and banks to those taking credit risk below the AAs. Our debt recommendations will be including the better funds among such picks. 
7. We also think credit calls are better taken with individual corporate bond issuers. We will be covering public NCD issues more actively this year to flag opportunities and hope to introduce our Growth subscribers to privately placed bonds. 
8. Now that there is more than one route to directly buy g-secs we will be flagging good primary auctions for you to participate in, whether they are of T-bills, floating rate g-secs or very long tenor g-secs (15 year plus) which can double up as annuity products. Do open a direct gilt account either with a broker or with NSE goBid or with RBI RDG as soon as you can. 

Do keep a tab of our calls in the above options through 2022. We will come up with calls ranging from gilt issuances, debt instruments beyond the top-rated ones as well as debt funds.