It's time to invest in Bond Funds

Income funds—also known as bond funds—are subject of intense discussion today. There are two schools of thought on justification of investing in bond funds—with both sides presenting their line of thinking. Issues like high persistent inflation, interest rates, lack of industrial activity and upcoming general elections in 2014 unnerve the most informed investor today from writing out the cheque for bond funds today.

Here below we make a humble attempt to make out a case for bond funds.

Any market is basically a function of demand and supply. Prices rise if demand outstrips supply and vice versa. It has been observed over last couple of years that 10Yr G-Sec yields peaked between November—December and then rallied till February –March of the next year. This phenomenon played itself out as recently as in 2011, when 10Yr G-Sec yields peaked at 9% in mid-November and then rallied till 8.15% by February. This action unfolded without any rate cuts though which is noteworthy.

RBI usually steps up its OMO (Open Market Operations) towards the latter part of the financial year in order to cope with liquidity crunch in the system owing to seasonal leakages during the festive season.

OMOs are nothing but RBI buying Government bonds and thereby infusing liquidity into the market.

Having said as above, we believe the odds are presently in favour of a rally in bond market—rate cuts or no rate cuts—as in last 2 financial years.  A rate cut will be icing on the cake.

A look at the demand supply dynamics in the G-Sec segment:-

After the auctions scheduled for this week, the gross supply left is roughly Rs. 1, 09,000 crores. The demand may come in from the following categories:-

1.       Reserve Bank of India—Demand of Rs. 60,000 crores

Market expects a minimum of Rs. 60000 crores of G-Secs to be mopped up by RBI through OMO (Open Market Operation). Presently the liquidity deficit in the Indian market is expected to be around Rs. 1, 15,000 crores, owing to seasonal factors. This is far in excess of the comfort zone of RBI at Rs. 70,000 crores. (The comfort zone is 1% of NDTL which is Rs. 7 lac crores). NDTL stands for Net Demand and Time Liabilities.

2.       FIIs—Demand of INR 15,000 crores

Indian Government is expected to increase the FII limit in G-Secs and corporate bonds by another $5 billion each. FM has expressed his desire for INR to appreciate. Subsequent to his assuming office and backed by flurry of “reform” measures announced thereafter saw INR rally to Rs. 51.80 levels in early October2011 levels from INR57.25 in June 2011, falling

to INR 55 levels thereafter. It is therefore reasonable to expect Government to step up efforts to attract capital flows to stem the slide of INR. Hence, we can conservatively estimate a G-Sec demand of Rs. 10-15000 crores coming from FIIs.    

3.       Banks—Demand of Rs. 40,000 crores

The current deposit growth by banks is 13-14%. If they end the year maintaining this growth rate then they have to mobilize Rs. 2, 50,000 crores of deposits till 31/03/2013. Even if they buy 25% of these into SLR, it generates an additional SLR demand of Rs. 60,000 crores. Of this, even if we assume they buy G-Secs worth 2/3^rd of this incremental demand, there’s a demand of Rs. 40,000 crores

The total demand as listed above adds up to Rs. 1, 15,000 crores against a supply of only Rs. 1, 09,000 crores.—enough to exhaust the entire supply of government papers.

Further, likely demand from insurance sector, provident funds, and mutual funds have not been considered in the above—which will only further increase the demand. The analysis holds even if additional liquidity leakage of Rs. 20-30000 crores happens till 31/03/2013.

          

Given the above, it is clear that while rate cuts may be required to sustain a bond rally in the time ahead, they are definitely not needed to get the rally started from here on. The supply, or the lack of it, alone is enough to start the rally from here; and in the very foreseeable future. If investors believe the logic given above, then those still on the sidelines have every reason not to continue to wait any further.

Disclaimer:-

The views expressed above are personal views of the author. This article is based on information already present in public domain. Neither the author, nor his firm nor any of his representatives shall be held responsible for any damages, whether direct or indirect, incidental, special or consequential including lost profits or lost revenue that may arise from or in connection with the use of the information.