Viewpoint | Despite the rally in government securities, bonds still attractive

The monetary policy committee of the RBI voted 6-0 to cut the policy repo rate by 25 bps from 6.00 per cent to 5.75 per cent. They also changed the policy stance from “Neutral” to “Accommodative”, thus keeping the door open for further reduction in the repo rate.

In the post-policy press briefing, the RBI Governor raised serious concerns about the growth outlook, though it was not backed by any significant downward revision in GDP (gross domestic product) growth forecast. The RBI expects GDP to grow by 7.0 per cent in 2019-20, against the earlier projection of 7.2 per cent. With this forecast, the MPC(monetary policy committee) may not need to cut the Repo rate by a large extent to revive growth.

Maintaining liquidity critical

The RBI has now already cut the policy rates thrice from 6.5 per cent to 5.75 per cent within four months.

Now the focus should be on maintaining surplus liquidity in the banking system so that transmission of these cuts onto lower lending rates happens at a faster pace.

In the past, the RBI has preferred Open Market Operations (OMO) and recently introduced long-term FX swaps to infuse durable liquidity in the banking system. Although it can continue using these and long-term repos for liquidity infusion, we believe cutting the Cash Reserve Ratio (CRR) for banks can have a better impact in terms of transmission. Now, with LCR (Liquidity Coverage Ratio) in place along with the SLR (Statutory Liquidity Ratio), the RBI should take a fresh look at the CRR requirements, especially for its ability at having a lasting impact on the system’s liquidity and banks’ financial position.

For the bond markets, this was a good policy given the change in stance to accommodative opening up space for further rally in bond prices (fall in bond yields). Bond markets have already rallied a great deal in the last one month with the 10-year government bond yield down from 7.4 per cent in April to near 6.9 per cent now. However, at current levels it still looks attractively valued as more rate cuts get priced in.

Bond funds with longer maturity profile may benefit from the rate cuts, though liquid fund returns will likely fall with the cut in Repo Rates and the desire to keep surplus liquidity. Dynamic Bond Funds, which allow the fund manager the flexibility of changing the portfolio positioning depending on the emerging situation is a better alternative for investors who wish to allocate a portion of their portfolio to bond funds and have a holding period of 2-3 years.

Investors with a low risk appetite should stick to 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.

The RBI disappointed the markets but was prudent in not announcing any big bang liquidity measures immediately which was seen in the sharp fall in the equity markets. However, they set up a working group to review the existing liquidity framework and they have also assured the market of timely response to the NBFC issue.

We believe the credit crunch in the NBFC space is mainly due to Investors’ trust deficit over the financial position and asset quality of some non-bank lenders. Thus mere liquidity infusion may not be able to resolve the issue.

Investors should also note that the credit crisis which began in the bond markets in September 2018 is not over yet and investors should remain cautious and should always choose debt and liquid funds that prioritize safety and liquidity over returns in the current times.

 The writer is Head-Fixed Income & Alternatives, Quantum Advisors Pvt Ltd

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Author: Roky