Bond Market Drama!!!

A stunned, disbelieving hush descended upon the world as COVID struck. It was as though a cord had been brutally yanked, abruptly cutting off power to a TV blaring at full volume. Right from business activities to jobs to Government’s finances, everything was in tatters. One must have got an idea that the bond market activities bear some relation to COVID but don’t exactly know how. Worry not, in this article I will explain about the recent activities in the bond market and how RBI is pulling the strings despite so much going around.

Concept of Yield (For those who already know, you may skip this and read from next heading onwards)

First I shall explain the basics of bond markets. Bonds, unlike equity, are fixed income instruments guaranteeing the investors a fixed source of income at pre-determined fixed intervals. For the uninitiated, the most commonly used term in bond markets is ‘yield’, which means the return investors get on their bond investments provided they hold the bond to maturity. For eg, If an investor purchases a bond which has a Face Value of Rs.100 for Rs.90, having a coupon(interest) rate of 5% with an original maturity of 5 years. For the first four years, investors will get Rs. 5 as interest and in the 5th year, investors will receive Rs.105 (Rs.5 of coupon and Rs.100 Face Value). As per the mathematics, the yield works out to be 7.47% (I am not getting into the granularity of calculations).

So, the point I want to make here is although the investor used to get only 5% interest on his investment, the yield works out to be 7.47% since there’s an element of capital appreciation as well (Receiving Rs.100 on maturity at the end of 5 years for which you had initially paid Rs.90). Got it? Makes sense? Okay, let’s proceed.

Just as stock prices change every second, yields exhibit a similar behavior, be it for Government bonds or corporate bonds. Having explained the concept of yield, bond prices and yields are INVERSELY RELATED, meaning if yields move up, bond prices fall down and vice versa. A lot of investors dedicatedly invest in bond markets based upon their expectations of future interest rate movement. For eg, I expect the yields to fall 3 months from now, I will purchase the bonds in anticipation of price increase. And as expected, yields fall. Prices rose. So I made a profit on my investment. Inverse relation, remember!!

What drives Yields?

Yield is nothing but market consensus. What the market participants are expecting to earn out of their investment and there are multiple factors which drive yields viz. inflation (Higher the inflation, higher would be the yield expectations to earn inflation adjusted returns), credit profile of the borrower (Riskier the credit profile, higher would be the yield).

What’s happening currently?

Government, one of the many disturbed by the pandemic is looking to raise funds to meet its expenditure requirements and boost demand in the process. The budgeted borrowings by the Government for the entire fiscal year Apr’20 to Mar’21 is Rs.12 trillion out of which Government has already borrowed Rs.7.66 trillion as on 25th September. Now, as I had mentioned in the previous para, credit profile of the borrower drives yields. That is exactly what’s happening. Market participants fear that Government might borrow more than budgeted till the end of Mar’21, which is spooking the markets and driving up the yields. Investors are demanding a higher yield for the risk they will be exposed to. Think of it the other way, they fear that there would be an oversupply of bonds, driving the prices down, essentially driving up the yields (recall INVERSE RELATION).

RBI, responsible for managing Government’s finances is finding the yields to be too high and refusing to entertain investors’ demands of such high yields. RBI doesn’t want to set a precedent of higher yields. If RBI accepts a higher yield today, tomorrow the market might demand more. So RBI is playing safe. Yields demanded by the market participants were north of 6.3% much beyond the acceptable level of 6% by RBI. There are two reasons why the RBI wants to control the yields. The first reason and the obvious reason is to save the Government’s borrowing costs since a small movement in the basis points (100 basis points is 1%) of yields can cost the Government given the voluminous borrowings and the second reason is that RBI doesn’t want banks to invest their money in these bonds, which would hamper the lending activity which is much needed to boost the demand. Banks, in lure of higher yields would naturally be attracted to invest in these bonds instead of their core task, lending. Thus, the resistance by RBI.

Bond Devolvement:

RBI, being the money manager of Government, conducts auctions of Government bonds. Just as Companies appoint a merchant banker while coming out with an Initial Public Offering (IPO), RBI appoints Primary Dealers (PD). PDs are underwriters, in that they undertake to subscribe the unsubscribed portion of the bond offerings in an auction. Devolvement is a process wherein the underwriters have to fill the gap left behind by subscribing to the securities which are unsubscribed by investors.

As on 11th of September’20, bond devolvement happened 3 out of the last 5 auctions because of the above mentioned reason, yield demanded by investors is more than what was acceptable to RBI. RBI refused to budge. It didn’t want to accede to the demands of the investors. Thus, the PDs had to chip in. This is not a favorable situation for the underwriters either since they have to be content with the 6% yield offered by RBI. But RBI contends that it has increased the underwriting fees implying that the PDs are safeguarded.

Investors are demanding that RBI should chip in by conducting Open Market Operations (OMO), much like the Quantitative Easing done by Central Banks abroad by buying Government bonds so as to arrest the fall in price due to oversupply, which would in turn bring down the yield. RBI has finally dropped some hints that it would conduct OMOs bringing in much needed relief for the bond markets. Infact, news had it that a few days back RBI anonymously purchased bonds from the secondary market which cooled down the yields. Therefore, existing investors heaved a sigh of relief as the value of their holdings increased due to the fall in yield.

State Development Loans (SDL)

States have been shattered. A pall of gloom has descended upon them. Finances in total disarray, issues of migrants and non-receipt of GST compensation cess from the Centre adding fuel to the fire,. You name the problem and they have it. States raise money at a spread to the G-Sec yield. Some states are raising debt at a whopping ~6.50-6.55%. In order to alleviate the stress faced by them, RBI just recently announced that SDLs would also be included in its OMO and that is a huge announcement. Much to cheer about!!

That’s it. I hope you enjoyed reading as much as I enjoyed writing and got to know something new. If you haven’t understood something, you can always feel free to reach out to me. I would be happy to help :)