Are interest rates poised for reversal?

An important development for the Indian economy in recent years has been the remarkable success achieved in lowering interest rates. This came about because the RBI had been steadily cutting its key policy rate since January 2014 when the repo rate had peaked at 8 percent. By August 2017, the repo rate had come down to 6 percent (where it stands today) for a total reduction of 2 percentage points over four years. The RBI’s move to cut interest rates over the last 3 to 4 years followed the decline in India’s inflation rate and indicated its confidence in the government’s ability to keep a tight lid on fiscal deficit.

The economy wide decline in borrowing costs has been beneficial to industry and business across sectors and this is one of the reasons why stock markets in India have boomed recently. For example, NBFCs have done well in recent years because the fall in interest rates made them more competitive vis-à-vis the banks, adding to their profitability.

Against this backdrop, recent events suggest that an unwelcome reversal of the trend may be in the offing.  While the RBI has held rates steady since the last cut effected in August 2017, it is the action in the bond market that is a pointer to the turbulence that lies ahead.

Signals from the bond market

Before getting into the recent action in the bond market, a brief word about how the bond markets work for the benefit of those readers who may not be aware of its dynamics.

The bond market trades in bonds just as the equity market trades in equity shares. A bond is defined as “a fixed income investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate.” In other words, while an equity share represents fractional ownership of the company, buying or holding a bond makes you a lender to the company (or government, as the case may be).

As in the equity markets, bond market participants cheer when the prices of bonds go up. However, unlike the equity markets where prices are influenced by a variety of factors, the price of bonds is determined by the prevailing interest rates. When interest rates rise, the value of bonds issued earlier (offering a rate of interest lower than the current rate) will fall to the extent that its yield is equalised with the current interest rate. Likewise, when interest rates fall, the value of bonds issued earlier (now offering a rate of interest higher than the current rate) will rise to the extent that its yield is equalised with the current interest rate.

This is best illustrated with an example. If the current interest rate is assumed at 10 percent, a bond with a face value of Rs.100 will pay the holder a sum of Rs.10 every year.  If interest rates remain unchanged, the bond holder will also be able to sell it in the bond market at its face value of Rs.100 (which is also his purchase price in this example). However, the question is, what would happen to the price of the bond should interest rates go up, say, to 20 percent?

At the new rate of interest, a (newly issued) bond will pay Rs.20 annually while the earlier bond fetches only Rs.10 per annum. Therefore, the old bond will find a buyer only when its return (or yield) is equalised with the new rate of interest. In this case, if the price of the old bond falls to Rs. 50, the yield for the buyer will amount to 20 percent as he earns Rs.10 annually on his investment of Rs.50. At this price, an investor in the bond market can buy a newly issued bond of Rs.100 or buy two bonds of the earlier issue at Rs.50 each, and be equally well off. Likewise, in the case of a fall in interest rates, bond prices go up to the extent that yields are equalised. A close look at the above explanation will also tell you why bond yields and prices move in opposite directions, i.e. when yields go up, prices fall, and vice versa.

India’s Bond market rallied from 2014 onwards

Thanks to interest rates falling steadily since 2014, the bond market participants enjoyed a rally in prices for much of the last four years. Yields had fallen from its peak of 9.10 percent in April 2014 to 6.19 percent in November 2016.  The sustained decline in bond yield was mainly due to the easy monetary policy followed by the Reserve Bank of India (RBI) after January 2014, with the repo rate brought down from 8 percent in 2014 to 6 percent as of today.

Yield on 10 Year Indian Government Bonds

   * Lowest point in 2017

Reversal of trend

The decline in bond yield (in other words, rally in bond prices) came to a halt by November 2016 as the RBI neared the end of its easy monetary policy cycle, with only one rate cut taking place thereafter (in August 2017).  The RBI was not in a position to push for further rate cuts despite the slowdown in the economy (following demonetisation) because of the risk of higher inflation heightened by the increased borrowing by the government. Indeed, the increased borrowings had caused the yield on the 10 year benchmark bond to go up from 6.4 percent to nearly 7.8 percent during the period from July  2017 to February 2018.

In fact, yields on government bonds increased across maturities, with the yield on short term treasury bonds of 364-days increasing from 6.27 percent to 6.57 percent while the 91-day T bill moved up from 6.05 percent to 6.44 percent

The spread between the 10 year benchmark bond yield and the repo rate has widened considerably since the August policy rate cut (as depicted in the above diagram), which is an indication that the market is anticipating even higher government borrowings, and therefore a larger supply of government bonds in future.

Negative impact of rising yields

The overshooting of the fiscal deficit in FY 2017-18 and the revised higher deficit estimated for the current FY 2018-19 will put further pressure on bond yields. The rising yield increases inflationary pressure (by pushing up costs for producers) and can lead to a slowdown in private investment and economic growth. As the supply of government bonds increases, it tends to “crowd out” private borrowers and forces up interest rates for them.

Banks are also adversely affected by rising yields as it erodes bond prices and the value of their existing bond portfolio. The higher mark to market losses that banks are forced to book will further erode their profitability at a time when it is already strained by non-performing loans. The cost of raising deposits for banks has also increased in recent months. Although RBI has kept policy rate unchanged since August 2017, India’s banks have been finding it difficult to lure bulk deposit as liquidity has dried up with the increasing demand for working capital from companies and the rise in bond yields across various maturities.

Moreover, with Basel III norms to be adopted fully by March 2019, banks have started maintaining higher Liquidity Coverage Ratio (LCR). The rise in LCR accompanied by lower liquidity and higher marginal cost of funds based lending rate (MCLR) will push up deposit rates. Most banks have raised their MCLR by 5 to 10 basis points since January 2018, even before the RBI begins increasing policy rates. Corporate entities are finding it harder to borrow from banks at competitive rates. Earlier, higher rated corporate could borrow via corporate bonds at lower yields compared to bank borrowings. In a scenario of rising yields in the bond market, this window is also turning costlier. 

Outlook

As in India, bond markets in the advanced economies have also witnessed rising yields (and falling prices). Recently, the US Treasury bond yield hit its highest level in four years. The 10-year UK and German government bond yields also rose to their highest levels since 2016. With central banks in the west gradually unwinding their stimulus packages, liquidity is likely to dry up and we may even see capital outflows from emerging markets. In this context, any deviation by the Indian government from the path of fiscal prudence will further pressurise the 10 year benchmark yield given the limited scope of help from central bank. And that, as we have seen, can only make things more difficult for corporate borrowers who are now well advised to get used to a period of belt tightening.

V.P. Nandakumar