The shorter end of the yield curve looks attractive

Morningstar India's Investment Management Team shares their views on portfolio positionings post the RBI policy.
By Morningstar |  08-02-19 | 

RBI cuts policy rate & shifts stance back to neutral

RBI, in its sixth bi-monthly Monetary Policy Committee (MPC) meeting, decided to cut the policy repo rate by 25 bps from 6.50 per cent to 6.25 per cent. Consequently, the reverse repo rate stands adjusted to 6.0 per cent, and the marginal standing facility (MSF) rate and the Bank Rate to 6.5 per cent. The MPC members unanimously decided to change the monetary policy stance back to neutral from calibrated tightening. Though the shift in stance was expected by the market, economists were divided on the policy rate action and so were the MPC members, with Dr. Chetan Ghate and Dr. Viral V. Acharya voted to keep the policy rate unchanged.

RBI has made a downward revision to both inflation and growth numbers. Headline inflation in December policy for H1 2019-20 was projected in the range of 3.8-4.2 per cent which is now revised to 3.2-3.4 per cent with risks broadly balanced, against risks tilted to upside mentioned in the earlier statements . GDP growth for H1 2019-20 was earlier projected at 7.5 per cent, which is now projected to be in a range of 7.2-7.4 per cent. Several factors provided MPC a room to go ahead with a rate cut. Consistent fall in food and fuel prices, benign food inflation outlook, widening of output gap and lower growth rate projection for H1 2019-20 amid slowing global growth.

Our view

The policy rate cut came as a surprise as the expectation was that RBI would probably shift their stance from calibrated tightening to neutral and watch the inflation trajectory for another few months and then if required initiate a rate cut based on developments on inflation & growth. Although, the rate cut would benefit the economy provided efficient transmission of lower rates by Banks & other lenders.

The change in stance along with downward revision to growth and inflation projections would provide flexibility to RBI to cut rates further over the next few months. RBI would watch incoming data on inflation and growth before taking any action on the policy rates. Further, unlike previous policy statements there was no mention of concerns related to fiscal slippages at central/state levels which might crowd out private investments. Though, the Governor did state that the inflation projections accounts for any potential impact of fiscal policies. Also, uncertainty around outcome of the upcoming general elections, crude oil prices, concerns over high core inflation and inflationary impact due to fiscal slippage could limit this flexibility.

Over the past few months, long term bond yields have witnessed a sharp drop from levels of 8.15% (10-year G-Sec) to 7.32% (after today’s policy announcement), in line with lower inflation prints and fall in crude oil prices. However, increased market borrowing via central/state government securities and T-bills for FY19 and FY20 along with reduced OMO purchases in coming months with improvement in liquidity situation may put some pressure on G-sec yields. Short term corporate bond yields including those of NBFCs and HFCs continue to trade at elevated levels as concerns over defaults, downgrades and liquidity tightness in the credit market persist. Spreads on 3-5 year corporate bonds over G-secs have widened meaningfully, which are now above long-term average (5 years) and close to levels seen in 2013.

  • Yields are looking attractive particularly at the shorter end of the yield curve with spreads of corporate bonds over G-Sec currently above long-term averages.
  • However, one needs to be mindful of the current stress in the credit market and stick to AAA rated short-term corporate bonds and bond funds from a risk-return perspective.
  • In line with our view, we continue to hold short-term, and corporate bond funds with superior credit quality in our model portfolios.
  • Based on our assessment, shorter end of the yield curve continues to look more attractive than longer end and we’ve positioned our portfolios accordingly.
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