Note to fixed income investors – 07 Jun 2024

The newly constituted Monetary Policy Committee (MPC) of the RBI with three new external members, decided to keep the policy repo rate unchanged at 6.5%, tenth pause decision in a row. Consequently, the standing deposit facility (SDF) rate stands unchanged at 6.25% and the marginal standing facility (MSF) rate and the Bank Rate unchanged at 6.75%. The MPC decided to change the stance from ‘withdrawal of accommodation’ to ‘neutral’ and to remain unambiguously focused on a durable alignment of inflation with the target, while supporting growth.

Some of the key mentions in the policy statement: 

1. The MPC reiterated that enduring price stability strengthens the foundations of a sustained period of high growth
2. The change in stance provides flexibility to the MPC while enabling it to monitor the progress on disinflation which is still incomplete

The change in stance to neutral signals a possible start of rate cut cycle later in the financial year. Markets reacted positively to this development with 10-year benchmark G-sec yield falling by 7 bps. The recent 50 bps rate cut by US Fed and expectations of further 50 bps rate cut before the calendar year end should provide comfort and maintain real rate attractiveness. Also, strong FPI flows in the Indian bond market and government’s adherence to fiscal prudence is supporting positive sentiment.

The current macroeconomic situation with GDP growth projected at ~7.2% for FY25 and inflation projected at 4.5% (but above the RBI target of 4%), balances the growth-inflation dynamics. Headline inflation has moderated lately and is expected to follow the disinflation path, barring September print amid base effect. The domestic growth outlook has been supported by private consumption and investment, although few high frequency lead indicators suggests moderation. However, above average monsoon and festive season should help boost rural consumption demand in the coming months. The recent surge in global geopolitical risks, financial market volatility and spike in global commodity prices could act as near-term factors to imbalance the growth-inflation dynamics.

The term spread between 3-month T-bill and 10-year G-sec has widened lately with improving liquidity situation. Although, the current spread of ~35 bps is still lower than the long-term average term spread of ~1.4%. This is expected to normalize further with improving banking system liquidity. The 10-year G-sec, in the short term, is expected to continue to trade in a range bound manner in the absence of any adverse event.

Strategy for fixed income investors:

•  With expectation of policy rates coming down, G-sec yields offer a decent accrual and a possibility of participation in capital appreciation over twelve to eighteen months. However, with recent fall in yields the expected quantum of incremental capital appreciation has reduced. Long-term yield could remain sensitive to the evolving growth-inflation dynamics. Despite this, the current medium & medium to long-term yield levels appear relatively attractive and gradual increase in debt allocation could be considered, to benefit relatively more with anticipated moderation in yields.
• Corporate bond spreads remain muted with AAA spreads still lower than the LTA amid lack of supply in the bond market. In select instances, spreads for AA and A appear attractive after adjusting for risk. Investor with an appetite for credit risk could start evaluating select high yield strategies.

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