What the Budget means for bond investors

With the Budget done and dusted, most commentators have pronounced that it is a good Budget for stock markets but an awful one for bond markets. But in our view, whether you – as a bond investor – should celebrate or mourn post-Budget, will depend on your present portfolio allocation to bonds and the kind of bonds you own. Here’s how the budget affects your bond investments.

Boost to bond yields

Even before this Budget came along, PrimeInvestor believed that market interest rates in India are set to climb this year, driven by a host of factors. Refer to the reasoning in our Debt outlook 2022. The Budget has added to our conviction.

Higher-than-expected market borrowings

When the market expects a large supply of government bonds to hit the market, it demands higher interest rates from the borrower or reduces its offer price. The Budget, by announcing a higher-than-expected borrowing programme for the Centre in the coming year, has fired up market yields for precisely this reason.

The reason stock markets were happy with the Budget is that they saw it as a ‘growth-oriented’ one where the Finance Minister was willing to spend freely on capex (outlays up 25%) to keep the economic revival going. But in the process, the FM pegged the fiscal deficit at an elevated 6.4% for FY23 against 6.9% for FY22. She seems to be in no hurry to shrink the deficit to more ‘normal’ levels of 4-4.5% right now. 

In absolute numbers, this resulted in a projected fiscal deficit of Rs 16.6 lakh crore in FY23 against Rs 15.9 lakh crore in the revised estimates of FY22. The only way in which the government can meet this shortfall between income and expenses is by borrowing from the market.  Quite apart from this year’s expenses being higher than income (which is the usual case), the government also has payments due on older loans this year.

As per budget documents, old loans coming up due amounted to Rs 2.7 lakh crore in FY22 but will amount to Rs 3.76 lakh crore this year. Now the government plans to settle part of these upcoming repayments by switching to new longer-tenure loans for old short-tenure ones (we advise you not to try this at home!). But this isn’t really expected to rein in the supply of government bonds next year. 

As the data below shows, the Centre’s gross market borrowings are expected to rise 43% from Rs 10.46 lakh crore in FY22 to Rs 14.95 lakh crore in FY23. After switches et al, net market borrowings are also expected to rise from Rs 7.75 lakh crore to Rs 11.12 lakh crore. Short term borrowings via T-bills are being reduced to Rs 50,000 crore from Rs 1 lakh crore.

Less reliance on small savings

In recent years, in a bid to help out small savers, the Centre had tried to route a significant chunk of its annual borrowings through the National Small Savings Fund or NSSF which invests the money raised in post office schemes. The central government tapping the NSSF (or its proxies like FCI or Air India doing it) also reduced the need for the government to borrow directly from the market and kept g-sec supplies low. However, in the interests of transparency, the Centre has been reducing this reliance. In FY23 it expects to borrow Rs 4.25 lakh crore from small savings against Rs 5.91 lakh crore in FY22. This too is adding to market borrowings.     

The plan to rely less on small savings will also mean that the Centre will be in no hurry to raise small savings interest rates, despite market rates moving up. When market interest rates were plumbing the depths the Centre didn’t cut small savings rates proportionately. Now it may choose not to react to the increases promptly too.

No clarity on global bond inclusion

Now, the markets may have been more cheerful about the extra borrowings had the FM acceded to the bond players’ wishlist and taken steps towards the inclusion of Indian bonds in global bond indices in the Budget. But that didn’t happen either.

Basically, for a long time, Indian debt market participants have been hoping for Indian government bonds to be included in global bond indices offered by providers such as JP Morgan, Morgan Stanley and Russell. While many hurdles in the way of such inclusion have been cleared as RBI has gradually relaxed the curbs on foreign participation in Indian bonds, two obstacles seem to remain – the facility for Indian bonds to be listed on global exchanges like Euroclear and the lack of clarity on taxation of such overseas trades. The bond lobby was hoping that the FM would pave the way for both in the budget by exempting such offshore trades in Indian g-secs from capital gains tax. 

As this didn’t materialize, the bond markets’ hopes that a new set of buyers could be found overseas for Indian g-secs were dashed. Had the changes come through, markets were expecting this to facilitate a $30-45 billion inflow into Indian g-secs in the first year with $15-20 billion of flows in subsequent years. This was in fact the reason why not just g-sec prices, but also the Rupee wilted a bit after the Budget. 

While the markets are disappointed, we think that reform moves or tax measures to smooth global bond index inclusion can be announced in the upcoming months too. Should this move materially suddenly, the upward move in Indian g-sec yields can get capped. In any case, with India’s GDP growth unlikely to get back to 8% levels we believe both policy rates and g-sec yields are unlikely to go back to peaks of the earlier cycle (10 year above 8% and repo above 6%).  

We should also remember that when market interest rates spike, old g-secs lose value. This hurts not just banks who own a huge stockpile of government securities but also RBI itself which now owns nearly Rs 6 lakh crore worth of g-secs, thanks to its open market operations. This too will exert pressure on regulators (read RBI) to intervene in markets before the yield spike gets out of hand. 

We therefore think that bond investors with long horizons should not expect yields on the 10-year g-sec to get to levels of 8-9% hit in the previous cycles before making their long-bond allocations. A range of 7-8% would be good enough to invest.

What you should do

In effect therefore, if you already have a lot of your net worth invested in long-dated bonds, the Budget may be bad news in the short to medium term as you may need to brace for mark-to-market losses this year from rising bond yields. This applies to medium to long duration debt mutual funds too if you have entered them with a short-term horizon. 

But if you have been listening to our advice and keeping to short term deposits, small savings and safe deposit products for your income and safety needs, you will have a world of new opportunities opening up to earn attractive rates on high-quality securities in the year ahead. Broadly, your bond strategy should be as follows:

• If you own a high allocation to 5-year plus bonds or gilt funds or their proxies like constant maturity funds then consider adding short-term or floating rate products to improve overall portfolio returns and tide the volatility in long-dated instruments. Apart from GOI Floating Rate Savings Bonds sold by RBI, there are ultra-short debt funds and floating rate funds to play this opportunity.  We assume that your long duration funds are only for your long-term goals that are at least 5 years away. If you hold them for the short term then you run the risk of losses and will have to consider switching them to shorter-term options now. You do not need to make any changes if you are holding our 7-year plus portfolio. 
• If you are thinking of parking money in bank FDs now with a 1-3 year window, you can consider T-bills or 1-3 year G-secs.  
• With yields on 10-15 year g-secs in recent auctions already topping 7%, it is time to start investing long-term money in dated g-secs. Primeinvestor will be specifically alerting you to attractive opportunities to invest in primary g-sec and SDL auctions in the coming months. 

While we won’t recommend you allocate any debt money where you need liquidity into g-secs/SDLs, you can use them as substitutes for annuity products sold by insurers and for your long-term goals such as retirement. This previous article offers a primer to the caveats and checks while investing in g-secs.