Summary

• 10-year Government of India (GOI) bond yields shot up by 27bps in December, marking a fifth consecutive month of rises. The yield curve also steepened, especially in the 1-10 year segment and corporate spreads widened by 7bps, reflecting weak market demand.   
• Acceleration in consumer price inflation (CPI) to 4.9% in November – a 15-month high – and fiscal data providing partial support to concerns about fiscal slippage contributed to the sharp surge in yields, particularly towards the end of the month.
• The Fund’s performance received a boost from the Indian rupee’s appreciation against the globally weak US dollar despite an ebb in portfolio capital inflows last month, especially in the equity markets.

Market update - Fiscal slippage and rise in CPI send yields surging

The domestic bond market opened the month on a somber note due to concerns about fiscal slippage, partly validated by the release of fiscal deficit data. The April-October 2017 fiscal deficit stood at INR5.25trn - 96.1% of the budgeted fiscal deficit for the entire year compared to 79.3% for the corresponding period in the previous year. The central government announced on 28 December additional borrowing of INR730bn in the current fiscal year ending 31 March 2018, roughly 0.5% of GDP. This announcement of extra borrowing led to a sharp rise in yields across the curve as the month and the calendar year ended.

Results of the Gujarat State assembly elections announced during December added further fuel to concerns about the government’s ability and willingness to maintain fiscal discipline. Although the ruling party (BJP) managed to win in Gujarat, it lost vote share in the rural regions of the state. This prompted fears amongst analysts that in the upcoming Union Budget, the government’s focus could shift away from fiscal discipline and it could increase inflationary spending in rural areas with the aim of winning various state elections in 2018 and the general election in 2019.Headline consumer price index (CPI) accelerated to a 15-month high of 4.9% year on year (YOY) in November, compared with 3.6% YOY in October. Higher-than-expected increase in food and fuel prices contributed to this surprise surge in CPI. Core inflation (ex-food and fuel) also moved up to 4.9% YOY from 4.5% YOY previously. The increase was broad based, with the clothing category recording a more prominent uptick. The implementation of the House Rent Allowance (HRA) continued to augment the housing category segment of the CPI. While the seasonal increase in vegetable prices could reverse slightly during the winter months, the implementation of HRA-related hikes by more states and sectors in the coming months will continue to push up the housing category of CPI. Furthermore, the rise in global oil prices could continue to put upward pressure on headline inflation.

Strategy

The Fund will continue to keep duration short and its allocation to corporate bonds at its current high level so long as yields remain on an upward trajectory. The Fund Managers will take their cue in the near term from details on the issuance of bank recapitalisation bonds and the Union Budget in February. Over a little longer-term, we would monitor assembly elections in a couple of large states to gauge the course of fiscal policy and its impact on yields.