I had an opportunity to meet with a group of investors last week. The discussion revolved around the present market conditions and the likely direction of equity and bond markets over the next few months. The views about the equity markets were divergent. However, the views about the bond markets were surprisingly similar. A substantial number of people believed that the interest rates have peaked and may move lower in the next 6 months. Long bonds thus appeared as a consensus trade. Almost all of them have been advised by their respective advisors (or friends) to increase the “duration” of their debt portfolio to avail maximum benefit of the declining interest rates.
A deeper inquisition highlighted several interesting issues related to the “long duration” positioning of the investors. I want to share some of these issues with the readers to seek their views in this regard.
· Most of the investors were not fully conversant with the concepts like “duration” and “modified duration” of bonds. They believed “residual maturity” and “duration” are the same things.
“Modified Duration” is a measure of the sensitivity of bond prices to the change in interest rates. Simply put, if a one percent move in bond yields results in a 5% change in the underlying bond prices, the bond is said to have a modified duration of 5yr.
The point to remember is each category of bonds reacts differently to the change in repo rate by RBI. Government securities, corporate bonds, and low-rated (junk or high-yield) bonds will react in different measures to any policy rate change.
· Even professionals like Chartered Accountants and MBAs assume a direct correlation between bond yields and RBI policy rates.
Interest rates (and bond prices) are a function of the demand and supply of credit. RBI policy rates do provide a broader direction to the credit demand and supply, but it is not necessary that in the near-term RBI rates and bond prices will have a direct correlation.
For example, if the fiscal deficit for FY25 is budgeted at more than the presently forecasted 5.3%, the supply of fresh bonds to be issued may be higher resulting in lower bond prices; even if RBI stays put or implements a 25-35bps cut in repo rates over the next 6months. Long-duration bonds may not yield any capital gains or may result in some MTM losses.
In recent years, the government has relied heavily on high-cost small savings to fund its fiscal deficit. Besides, RBI has systematically constricted the banking system liquidity. This has put pressure on deposit flows to commercial banks, resulting in higher costs of funds for banks. Bank lending rates have shown a tendency to rise even though RBI is stayed put for the past six months. Retail inflation has been sticky (closer to the upper bound of the RBI tolerance band) and the WPI inflation has shown a tendency to rise in recent months. FDI flows have slowed down materially in 2023. FPI flows have also reversed in recent weeks.
In my view, there is no strong argument to support the assumption of RBI cuts. Besides, equity market positioning (sharp rise in private capex, rise in consumer credit, and discretionary spending) supports higher credit demand. Logically, the long bond trade appears more driven by emotions and speculation than an economic argument. It is also a case of cognition dissonance in case you are also long on growth, credit, and capex on your equity portfolio.
