Debt Monthly View for June 2024

In June, a significant event transpired when Indian government bonds were added to the JP Morgan Emerging Markets Index. This inclusion marked a milestone for the Indian financial market and highlighted the growing importance of India in global investment portfolios.

During the month, the 10-year benchmark government bond yield remained in a tight range between 6.96% to 7.04% and closed the month marginally higher at 7.0% against 6.98% on May 31, 2024.

Money market rates cooled off slightly. The 3-months Treasury bill yield ended the month at 6.80% for June against 6.89% for May. This move was largely in response to the surprise reduction in the T-bill issuances by Rs 600bn during Q1 FY24 and government bond buyback worth Rs 72.88 bn of notes maturing in less than six months. These measures eased the liquidity pressure somewhat amid sluggish government expenditure.

The yield on the short-term money market securities such as commercial paper (CP)/ certificate of deposit (CD) plunged owing to surplus liquidity at a banking system post increase in government spending. At the month end, 3 months maturity AAA PSU papers were trading close to 7.05%-7.15% levels.

Relative easing in liquidity conditions: Banking system liquidity eased relatively during the month while remained in deficit for most parts of May. The average monthly liquidity faced a deficit of Rs 0.549 trillion, compared to an average deficit of Rs 1.37 trillion. This was primarily due to the accumulation of government balances during May, and its effects continued into June.

The prevailing deficit liquidity at banking system level led the RBI to attempt 5 VRR and buy-back during the month. Core liquidity too continues to remain in a surplus. We believe liquidity conditions shall slowly improve, accounting for a potential spending increase in the first half of the fiscal year.

Inflation: The headline CPI inflation for June 24 was 4.75% (lowest in the last 13 months) and CPI ex-vegetable which captures around 94% of the total CPI basket, fell to 3.52% vs 3.74% in February 24). Core CPI (ex-Food and Fuel) also continued to hit new lows to 3.15% (vs 3.2% in April 2024, below RBI’s 4% target).

While the RBI estimates that CPI will average 4.5% in FY25, we believe there’s a high probability of a downward surprise to this estimate. Based on the current trend, we expect core CPI to remain below 3.5% throughout FY25.

As inflation pressures ease, the inflation risk premium on bonds should decrease, leading to lower bond yields even without an official rate cut by the RBI. Any increase in the probability of a rate cut would further intensify the downward trend in bond yields.

Bond Index Inclusion: The debut of Indian bonds in the JP Morgan Emerging Markets Index marked a milestone for India’s fixed-income markets. While there was optimism surrounding the inclusion, actual yield movements remained relatively flat. The inclusion is estimated to bring substantial inflows ($30-40 bn) into the Indian bond market. Higher foreign demand for bonds with supply side in check can drive up prices and lower yields thus the impact of inclusion is a big positive for the bond markets.

Outlook

The near-term outlook for the bond market will be shaped the upcoming budget which will set the tone of fiscal policy of the new coalition government. As broadly expected, the government might increase its expenditure to boost domestic demand. This can be comfortably funded by the larger than expected RBI dividend to the government.

We expect the government will continue with its fiscal consolidation plan and keep the market borrowing under check. There is also a possibility of reduction in the fiscal deficit and borrowing amounts from the interim budget estimates.

We hold a positive outlook on the fixed income market from medium term perspective, considering:

• Favourable demand supply mix in government bonds
• Increasing participation by foreign investors with index inclusion
• Declining inflation trend
• Possibility of rate cuts by the RBI
• Softening global environment with declining global growth and expectation of rate cuts by major central banks

Given the possibility of decline in bond yields over medium term, long-duration bonds may offer attractive return potential. Investors with a 2–3-year horizon may consider dynamic bond funds, which can adapt their portfolio positioning based on market conditions.

Investors with a short-term investment horizon and with little desire to take risks, can invest in liquid funds which invest in government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default.

Source: RBI, Bloomberg

Above article is authored by Quantum.

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