The government securities (Gsec) market, the first to react to news and events in the bond market, has given a thumbs down to the Union Budget 2018. The (new) 10-year Gsec, 7.17% GoI 2028, was trading at approximately 7.6% towards the end of the day on February 1, against approximately 7.4% in the morning. The (old) 10-year benchmark, 6.79% GoI 2017, was at approximately 7.8% by the end of the day, against 7.6% in the morning. An uptick in yield of 20 basis points in a day is steep, indicating a significant fall in prices.
So what did the Budget propose which the Gsec market cannot digest?
1. Fiscal deficit: Clearly, there has been a slippage. The government has revised its fiscal deficit target from 3.2% to 3.5% for FY 2017-18. In absolute terms, it is up from Rs.5.45 lakh crore to Rs.5.95 lakh crore. For the next year, the government has revised its target from 3% to 3.3%. Not a good sign.
2. Inflation: Markets did expect the government to take populist measures benefiting farmers. And sure enough, the government has hiked minimum support price (MSP) of all crops to 1.5 times (150%) of the cost of production. So far, such a rate was applicable for rabi crops. With this, the government will implement this rate for kharif crops as well. While it is a positive measure socially, to encourage farmers with such an incentive, one of the reasons CPI inflation eased over the past 3 years was lower hikes in MSP. And rising inflation has a negative impact on bond markets.
3. Government borrowing: The government has targeted its borrowing at Rs.3.90 lakh crore for FY2019, up from Rs.3.48 lakh crore. In FY2018, the government had to increase its borrowing to Rs.4.02 lakh crore due to higher borrowings and lower buybacks. From that perspective, the target of Rs.3.90 lakh crore for FY2019 is marginally lower than Rs.4.02 lakh crore for FY2018, barring any slippage.
Way forward:
The upcoming policy review meeting of RBI on February 7 will give some direction to the bond markets. While it is unlikely that the RBI will give any guidance on policy rates, the regulator’s take on inflation and MSP hikes will be interesting to watch.
What should you do?
Gsec provides value even at current levels. The spread between the overnight repo rate of 6% and 10-year G-Sec yield at 7.6% is 1.6%, which is higher than the historical average. If you have a conservative fixed income client, ask them to stay put and invest fresh money in short-term bond funds. If some of your clients are adventurous, you may recommend building positions in long-term bond funds.
Source: https://cafemutual.com/news/guestcolumn/327-what-does-budget-2018-hold-for-fixed-income-investors