The liquidity factor

Is it an end to the bull phase for debt investors?

The liquidity factor

Bond-market moves, like those of the stock market, depend on liquidity as much as fundamentals. The face-off between bond buyers and sellers does play a big role in deciding the volatility in market interest rates as well as their medium and long-term direction. On this score, the next few months promise to be rocky for bond markets.

On the sell side, while private corporate borrowings are muted, the Government of India as well as state governments are currently on a borrowing spree. Given the deficit overshoot, central borrowings may remain high in the next one year. On the demand side, however, buyers are turning more circumspect. Indian banks, the largest buyers of government bonds (due to statutory liquidity requirements) piled on in a big way to G-secs during and in the months after demonetisation. Slow credit offtake from companies also encouraged their G-sec buying spree. As rates fell, banks also made hefty capital gains on these long-term G-secs, which helped pad up their profits. But the recent spike in G-sec yields has turned those profits into losses, which banks can ill-afford.

With credit appetite also picking up, banks' incremental demand for G-secs may not be as robust as last year. Insurers and mutual funds may continue to lap up G-secs based on inflows from retail investors. But they too may prefer shorter-term bonds over long-term ones, given the uncertainty about rate direction. FPIs may continue in the on-off mode based on global cues and the RBI's willingness to lift the debt ceiling. The rates on shorter-term bonds are usually influenced by the liquidity that RBI makes available in the market. This has moved from surplus to neutral zone lately.

All of this points to a continued upward pressure on G-sec yields over the next few months. Taking cue from G-secs, corporate bonds are likely to offer higher yields, too.

Overall, reading the tea leaves, it appears that the factors exerting upward pressure on interest rates are winning this game, suggesting an end of the bull phase for debt investors.

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