When it comes to investments, we tend to predict market movements. For bond investments, we take a view on interest rate movements. To be noted, in bonds or bond funds, most of the returns come from the accrual, i.e., the coupon receipts and a small component comes from market movements.
In 2018, we saw yields on government securities move up significantly, then ease; interest rates on bank deposits inch up and returns on bond funds impacted adversely and then recover. Let’s look at the likely scenario for the new year.
The year 2018 presented a dichotomy of sorts: RBI increased interest rates twice, changed approach on rates from neutral to tightening (i.e., towards rate hikes) but inflation eased significantly. In November, CPI inflation was 2.33%, much on the lower side by Indian standards. This has led to expectations of rate cuts this year. Though inflation is expected to tick up from this level, it would be lower than RBI’s target of 4%.
Prior to a rate cut per se, RBI has to change the approach from tightening to neutral, which is expected in the early part of the year. If inflation remains benign over the course of the year and globally central banks of developed countries remain on the easier side of interest rates, rate cuts by RBI is possible this year.
Having said that interest rate cuts by RBI is possible, to what extent banks follow suit on their administered rates (deposit and loans) remains to be seen. Though RBI monitors whether banks are passing on interest rate signals, the benchmark for banks is their deposit rates, which is referred to as MCLR. Deposit rates of banks are a function of other factors like amount of funds they have, liquidity in the banking system, demand for loans, etc. Accordingly, banks may or may not pass on the interest rate signals from RBI.
In the secondary market for bonds, the first segment to react to interest rate signals or expectations on rate movement is government securities. That segment has already moved, i.e., interest rates have eased significantly from September till date. The next segment in secondary market is corporate bonds, where interest rates may come down over the course of the year, as that segment has not reacted as much so far, as government securities.
If interest rates indeed come down this year, it will be better for existing bond or bond fund investments on mark-to-market, as price and interest rates move inversely. When interest rates come down, prices move up. If banks reduce interest rates in line with RBI signal, which is through the overnight repo rate currently at 6.5%, it will better for borrowers.
Floating rate borrowings would be linked to an external benchmark going forward, i.e., it will move not as per the bank’s cost of funds but as per a designated parameter in the secondary market. If there is a rally in the market and interest rates come down it will help, but loans being of a long tenure, interest rate cycle may turn somewhere down the line. Interest rates coming down won’t be helpful for fresh investments in bonds or bond funds as those deployments would be made at lower interest rates.
Inflation will be the major factor this year; RBI looks at this for setting interest rates, and RBI repo rate is the guiding parameter for the entire ecosystem of rates. Food inflation seems to have gone through a structural improvement, which is a positive. Crude oil prices and global interest rates are relevant for RBI decisions, which also seem to be in place. Net-net, this year looks favorable for existing bond fund investments and borrowers.