The year 2014 may be remembered as one of the best years for Indian bonds. As global growth stumbled, commodity prices, especially that of crude oil, eased by over 50 per cent. These manifested in disinflationary trends globally.
However, the Indian economy saw a dramatic improvement in macroeconomic indicators due to lower oil prices and favourable monetary and fiscal policies. While CPI inflation eased from high double-digit figures in 2013 to a low of 4.5 to five per cent, the current account deficit (CAD) narrowed to around 1.5 per cent of GDP from four to five per cent in 2013.
In response to these macro-variables and a decisive outcome in the 2014 national elections, the benchmark 10-year government bond yield declined by around 100 basis points (bps) in the second half of 2014 to around 7.80 per cent. Amid falling commodity prices, improving CAD, healthy macroeconomic backdrop and strong FII inflows, the RBI began its monetary easing cycle in January 2015 by reducing the repo rate by 25 bps. In March, it cut the rate by another 25 bps.
The bond market sentiment will remain bullish in 2015/16 as the RBI is expected to announce two more rate cuts - likely by June and the fourth quarter. We expect CPI inflation to remain benign and average around five to 5.5 per cent. But investors should moderate their return expectations.
Global growth prospects are still anaemic and disinflationary conditions are getting pervasive. Although the US Fed has prepared the market for a possible rate hike later this year, its timing and pace remain uncertain. Other major central banks are still in an easing mode due to weak economic growth, despite a stronger dollar putting pressure on many currencies.
The European Central Bank and the Bank of Japan, in particular, are still delivering monetary stimulus to pump prime their economies. The effects of their actions are clearly visible through higher systemic liquidity and ultra-low bond yields in many European economies and in Japan. Nearly 24 central banks have cut their benchmark rates since the start of this year to March 12.
India is one of the few countries where both economic growth as well as nominal bond yields are still relatively attractive. More importantly, the rupee has remained relatively stable when compared to its Asian peers. These factors have resulted in huge investor appetite for Indian bonds. FII inflows into the bond market in 2014 stood around $27 billion; they have poured in around $7 billion year to date in 2015.
Despite investor sentiment improving post elections, credit growth remains sluggish and below its long-term average. The recent deflationary trend in WPI suggests a slack in the manufacturing sector. Companies with relatively higher leverage have little appetite for further borrowing. On the other hand, with inflation easing and higher real rates, deposit growth is likely to outpace credit growth. All these augur well for bonds as their demand from banks, insurance companies and foreign investors will likely remain robust in 2015.
We expect the government bond yield curve to steepen gradually from its current inverted shape. An upward sloping yield curve is an indicator of high growth. A gradual rise in systemic liquidity and rate cuts will likely result in higher decline in short- and medium-term bond yields as compared to long-term yields (above 15 years). The steepening of the yield curve will benefit bonds with five- to 10-year maturity as they are likely to outperform bonds with higher maturities (above 15 years) on a risk-adjusted basis.
(The author is Executive Vice President and Head of Fixed Income, DSP BlackRock Mutual Fund)