“So broadly, if you look at markets right now, on the cash markets, on the sovereign side, markets have been quite stable. There have been a lot of support that has been provided by the central bank to help stabilise markets. But on the non-cash side markets have seen significant volatility,” Bafna explained in an interview to ET Now.
He added that the Overnight Index Swap (OIS) curve has moved up significantly, pulling the corporate bond curve along with it. “Now in that background if you just look at spreads as compared to historical averages, spreads have become extremely attractive as against last March as well and the cost of carry has become extremely prohibitive primarily because in the entire market liquidity has gone into surplus with active intervention by the RBI again. So, with that carry perhaps is the right flavour of the market as of now given that overnight rates are still below 5%, today they have gone a little above 5% but over the last say fortnight or so they have been continuously below 5% and AAA segment non-SLR segment is trading above 7.25%. So, the spreads are extremely attractive and in turn the carries extremely-extremely attractive as against historical mean as well.”
Flows Into Fixed Income Mutual Funds
Bafna noted that inflows into fixed income mutual funds have been shaped by a mix of bank borrowing trends and market liquidity conditions. “Over the past quarter perhaps we have seen signs of that. So, if you go back a couple of quarters, we have seen significantly high credit deposit ratios for banks and given that is the case, so this then reads out in two parts.”
He explained that banks have increasingly borrowed from the market to support credit growth, which temporarily muted additional investments into mutual funds. “A large part of the brunt has been seen by the segments up to one year in terms of overall flows. Over the next quarter we expect that these flows as liquidity continues to remain in surplus, as we cross the quarter and this is a quarter end phenomenon every time that we see in terms of spreads widening but this time it has been a little higher as compared to historical patterns because of this phenomenon that credit deposit ratio has been higher and we have seen a significant amount of shift from corporates towards bank borrowings and therefore the impact on banks.”
Short-Term and Medium-Term Outlook
With regard to the short-term outlook, Bafna expressed optimism for investors seeking arbitrage opportunities. “In the shorter term, absolutely yes, the curve is expected to steepen over the next quarter or so. So, if you look at historical averages, so last March we had one-year series that had peaked out at 110 basis points over and above the effective overnight rates. We are somewhere in the range of 210-220 basis points right now. So absolutely yes, it is expected to steepen in the shorter term.”
Looking further ahead, he noted that inflation is expected to remain anchored near 4%, supported by the Monetary Policy Committee’s consistent track record. “Over the medium to long term, I mean inflation is expected to remain well anchored closer to 4% and we have seen the last decade how effectively the MPC has been able to ensure that inflation comes back within the target band and continues to remain within the band and therefore from an inflation comfort perspective we do not expect any rate actions on the hike side over the next 12 months and given that the cost of carry is extremely attractive. So, over the next 12 to 24 months if the investment horizon suits for the investor, you can look at a one to three-year product because on the duration side also one to three-year part of the curve looks extremely attractive.”
The 10-Year Bond Yield Puzzle
Bafna also addressed the relative stability of the 10-year India bond yield despite rate cuts. “So, this dates back to June when we had a frontloading of rate cut and post the frontloading of rate cut, markets anticipated that this is perhaps the end of the easing cycle and in turn then attributed the prevailing 10-year at that point of time to be the bottom. But if you go back in time over the past year given the changes on the equity front for long only investors, we have seen a significant amount of incremental investments going into equities especially for long only funds and therefore the flows towards the debt side of the market has been very muted by these participants.”
He noted that incremental demand from long-only investors is returning and that the government has maintained fiscal discipline, further supporting fixed income stability. “Apart from that the government has also been extremely focused on ensuring that the overall fiscal dynamics remain in line with expectations and in terms of the glide path also it is quite comfortable in terms of the glide path that they have given over the next five years.”
Bafna concluded, highlighting the relative attractiveness of non-sovereign fixed income instruments. “So, from that perspective while spreads look extremely attractive, so just to give you a reference, last 10-year median between repo rate and the 10-year benchmark yields is close to 105 basis points. We are trading at close to 140-145 basis points. So, from a median perspective, it looks extremely attractive but as compared to that I believe that the non-sovereign segment looks more attractive because the spreads are even higher.”