The Year 2020 – Fixed Income: Best of bond market rally over; lower expectations

By Pankaj Pathak

The year 2020 has been an extraordinary year on many accounts. It has been a year of facing, learning and adapting to the unknown. The manner in which various markets have responded to the crises would have altered investor behaviour as well.

Mixed performance
Fixed income investors witnessed another year of mixed performance across various categories. Interest rates on bank deposits and returns on liquid and money market funds continued to go down and now at levels last seen during the 2008 financial crisis. Credit risk funds had yet another painful year and in some cases wiped out a significant part of investors’ savings. Contrary to these, investors in long duration and high credit quality bond funds enjoyed another year of great performance.

The RBI continued its easy monetary policy by cutting policy rates and infusing a lot of liquidity into the banking system. The policy repo rate has been reduced by cumulative 115 basis points and the reverse repo rate by 155 basis points in 2020. This was after 135 basis points reduction in the policy rates in the last calendar year. The policy repo rate currently stands at 4% and the reverse repo rate at 3.35%

RBI’s action on liquidity was even more aggressive. Liquidity surplus in the banking system has been kept at over `6 trillion for most of the time this year. This high liquidity surplus has kept the short-term money market rates such as 3-month treasury bills or PSU CP/ CDs below the reverse repo rate. Currently, the 3-month treasury bills and PSU CPs are quoting below 3.2%.

Going into 2021, the drivers of fixed income performance are set to change. With inflation hovering above the policy repo rate, room for further rate cuts may not be available. We expect RBI to begin normalisation of monetary policy by middle of 2021.

Fiscal consolidation roadmap
Just like monetary policy, the government also stretched its fiscal position to deal with the crisis. Even before this pandemic, consolidated fiscal deficit of Central and state governments was at elevated levels. In the crisis it faced a double whammy of lower tax collections and an increased spending on healthcare.

In the current fiscal, the Centre’s fiscal deficit could rise to 8% of GDP while states could add about 5% of GDP. India’s public debt could jump to about 90% of GDP this year. This is one of the highest among similar rated emerging economies.

A medium term fiscal plan will be needed to bring down fiscal deficit. The government’s roadmap for fiscal consolidation will have a bearing on bond markets. Market will closely watch for cues in Budget 2021-22.

Outlook for 2021
In 2021, bond yields could reverse their downward trend and grind up towards the year end. Short end rates (up to three years maturity) are currently priced aggressively due to excess liquidity thus carrying maximum risk of reversal. The longer segment may continue to get RBI’s support from OMO purchases and twists. Thus the yield curve will likely flatten in the next year (short term rates move up more than longer ends).

Fixed income investors should acknowledge that the best of the bond market rally is now behind us. Currently bond yields are at multi-year lows and scope for capital gains look limited. Going into next year, investors should lower their return expectations from fixed income funds.

The writer is fund manager, Fixed Income, Quantum AMC