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Credit crisis is not over yet, choose debt mutual funds carefully

In the fifth bi-monthly monetary policy review meeting, the RBI had kept the repo rate unchanged, resulting in the yields spiking by 10-20 bps.

Dec 09, 2019, 10.54 AM IST
ET Online
Pankaj pathak1212
By Pankaj Pathak

Indian bonds had a lackluster month with yields trading in a narrow range throughout the maturity curve. The steepening bias continued in the market as short-term bond yields came down while the yield on longer maturity bonds inched up marginally.

The 10-year benchmark government bond ended the month 2 basis points higher at yield of 6.47% vs 6.45% in the previous month. While the front-end bond yields (up to 5-year maturity bonds) eased by 3-15 basis points in the same period.

Short-term rates were more influenced by the prevailing easy liquidity condition. In the past few months, the RBI has pumped in a lot of liquidity into the banking system to facilitate credit growth and transmission of past rate cuts. The liquidity surplus is now close to around Rs 2.5 trillion, most of which has come from the RBI’s purchase of foreign exchange. The RBI has bought over $20 billion of foreign exchange in the past two months.

This has also put downward pressure on the money market rates. Yield on 2-3 months PSU CPs fell below the repo rate of 5.15% and remained there for most of the month. It was also fueled by an expectation of further reduction in the policy repo rate by the RBI.

Contrary to the market expectation, the RBI kept policy rates unchanged at 5.15% while maintaining a ‘dovish’ tone, hinting scope of monetary easing in the near future. This came as a surprise to many as there was a near consensus expectation of another rate cut. The disappointment was also reflected in the market behavior after the policy announcement as yields spiked by 10-20 bps across the curve.

Since February 2019, the RBI has been prioritising growth, having already controlled inflation. The MPC has thus delivered 135 bps in rate cuts (1.35%) since February with five consecutive rate cuts to bring the repo rate down from 6.5% to 5.15%. During the same time, the GDP growth forecast of the MPC for fiscal year 2020 has fallen from 7% to 6.1% and then to 5% now. The 1-year forward headline CPI forecast has though remained below 4%. Thus, based on their own growth focus, there is still room to bring down the repo rate. This seems to us a temporary pause and we continue to expect additional 25-50 bps cuts in the policy repo rate by the RBI.

With monetary policy past now, the bond market will look closely to developments on the fiscal front. With sliding GDP growth and poor sentiment in the private sector, the government is in a tough spot to balance their budget. In our opinion, the government will miss its fiscal deficit target of 3.3% of GDP by 40-50 basis points.

However, at the current level of term premium with the 10-year government bond yield at 6.6% trading around 150 basis points over repo rate of 5.15%, much of the fiscal risk is already priced in the market. On the positive side, potential rate cuts and easy liquidity conditions will continue to support the bond market.

In our opinion, when fiscal uncertainty goes away, term premiums (spread between repo rate and yields on longer tenor bonds) on the long maturity bonds will likely correct. Though we do not see a structural bull run and any such positioning is only a tactical call.

We have maintained that the best of the bond market rally may be behind us now and Investors in bond funds should keep the market risks in mind while trying to benefit from any further fall in bond yields.

Investors with a low risk appetite should stick to short maturity funds or liquid funds to avoid any sharp volatility in their portfolio value. However, while choosing such funds one should be aware of the credit risk and prefer funds which take low credit and liquidity risks.

Investors should also note that the credit crisis which began in the bond markets post IL&FS default is not over yet and investors should remain cautious and should always choose debt and liquid funds which priorities safety and liquidity over returns in the current times.

(Pankaj Pathak is a fund manager-fixed income at Quantum Mutual Fund)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of

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