Explained: The Bond Market's Post-Budget Blues

Ramped up borrowings for FY23 budget gets a thumbs down.

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As the US Federal Reserve’s aggressive interest rate hike slated for March looms threateningly over global markets, Indian bond market participants are signalling that they are not on board with the Budget’s roadmap to ramp up funding on the back of higher borrowings.

Since February 1 – that is, after the Union finance minister Nirmala Sitharaman’s budget address – bond yields of India’s 10-year Government Security (G-Sec) rose to an intraday high of 6.95% before settling at 6.88% on Friday (February 4) last week. This rise, the highest level recorded in the last two and a half years, shows that bond yields are already flirting with the 7% barrier. Market experts suggest that in a span of two to three quarters the yields could be in the 7.25%-7.35% band, effectively making it dearer for the Indian government to raise funds.

The impact is not limited to the 10-year government paper alone. Corporate bonds were also hit. Yields on 10-year corporate bonds spiked up by 15-20 basis points (or bps) whereas three and five-year corporate papers saw their yields rising by 20-25 bps.

What’s causing the yield spike? 

Since February 1, the bond yields have been running uphill after the FY22-23 Union Budget’s market borrowing projections came out.

As per the budget, the government’s gross market borrowings are projected at Rs 14.95 lakh crore and net borrowings are estimated to be Rs 11.2 lakh crore. The gross borrowing figures are much higher compared to the Rs 12-13 lakh crore borrowings that the markets had accounted for, which is one reason why market participants have been pressing the panic button and pushing the yields to record highs.

Also read: The Winners and the Losers of Union Budget 2022

For now, things are likely to get a whole lot worse before they become any better for the Indian government’s borrowings plan. A combination of factors ranging from plummeting small savings schemes inflows, failure to enlist Indian bonds on global indices, absence of market breadth to absorb the supply and an imminent rate hike by the fed can keep yields elevated for some time to come.

Currently, participants are clued into the fact that the breadth of the market might not be as wide as expected for an elevated supply of G-Sec papers to be comprehensively absorbed. Compounding things all the more for the government is the Fed’s monetary tightening cycle that will take off from March this year.

The tightening has put not just the RBI but other central banks around the globe on the edge as the rate hikes spell the end of the accommodative stance adopted in the aftermath of the pandemic.

Meanwhile, the Indian government’s inaction when it comes to enlisting in the Belgium-based clearing house Euroclear – which would have exponentially increased the pool of investors for Indian debt papers and would have reportedly pulled in as much as Rs 1.5 lakh crore – means that the government will have to fall back on the usual suspects as far as raising funds is concerned.

In the line-up of investors are banks, insurance houses and provident funds. That the role of banks and insurance companies is overwhelmingly large can be seen from the fact that the duo accounts for 62% ownership of the outstanding dated government securities (as of January 31, 2022), totalling about Rs 80.8 lakh crore and due for redemption till 2061.

Another player in the mix, namely foreign portfolio investors (or FPIs), would have helped but then they have been keeping their distance from the Indian bond markets. In 2021, FPIs collectively took out Rs 10,359 crore from the debt market and had invested only about Rs 3,618 till February 7 of this year.

Also read: Budget 2022’s Big Infra Push May Flag in Face of Global Inflation

An SBI Ecowrap report sheds light on the dismal state of the general debt portfolio. It states:

“In the last two CYs 2020 & 21, positive inflows of Rs 58,000 crore have been seen only in Debt-VRR (attracting long term and stable investments with tenor commitment) leading to exhaustion of limits available while general debt portfolio has seen successive outflows in these years, with outflow in the first year of the pandemic being in excess of 1 lakh crore, showing the fragile, somewhat opaque and flight-prone underlying dotting the global monetary ecosystems as overall investment limits have largely remained underutilized in debt as well as corporate bonds dismally.”

The same report points out that the RBI will have to step in to meet demand of Rs 2 lakh crore through open market operations.

“Based on the ownership pattern of Government of India dated securities as on September ’21 and given the total net borrowings of Centre at Rs 11.2 lakh crore, we believe demand of securities from banks has to be around Rs 4.2 lakh crore (considering NDTL increase of 10% and 27% of SLR). The insurance sector could subscribe to Rs 2.7 lakh crore. This implies RBI would have to ensure demand of at least Rs 2.0 lakh crore. The rest amount will be purchased by PDs, Mutual Funds, FPI and others,” the report states.

Considering the strong supply of Indian papers and the absence of a robust fourth player, the RBI will have to intervene in the bond markets, failing which there can be a situation where there might not be adequate takers for the G-Sec papers in the market.

The inflation overhang

In the meanwhile, there is no wishing away the inflation sword hanging over the central bank. In the December Monetary Policy Review meeting, it projected retail inflation at 5.3% for the whole of FY22 while estimating it to be 5.1% in the third quarter of FY22 and 5.7% in the fourth quarter of FY22.

Also read: What the Economic Survey’s ‘Refined’ Core Inflation Tells us About Fuel Price Rise

Its predictions were delivered a shakedown when the retail inflation for the month of December inched up to 5.6%-the highest in six months and quite a strong leap from the 4.9% in November.

Going forward, RBI has the unenviable task of performing a balancing act ensuring that inflation is kept in check without shuttering down growth impulses. Doing this, even as global crude oil prices register 20% jumps since the beginning of the year, is a challenge of another order.

While consumer price inflation seems to be in the tolerance band, it is still hovering above the target of 4% whereas wholesale-price inflation is running in double digits. Considering that banks across the globe are now waking up to the fact that inflation is far from transitory, many are expecting the central bank to keep the repo rate steady while hiking up the reverse repo rate by as much as 20 bps in a bid to absorb excess liquidity from the system.

Even otherwise, the RBI has been taking the variable rate reverse repo auction route to pull out excess money from the system.