Have short term money to park? Here’s a cast iron option

Lately, it is not just India’s stock market that has been hopping all over the place like an impatient child. The bond market has been doing it too! India’s 10-year government bond yield, which sets the benchmark for all other debt instruments, climbed vertically from 5.8% in July 2020 to 7.61% in June 2022. But after that, it has been unable to make up its mind on whether to climb higher or pause for breath. 

This has made it important for investors in debt instruments to track market yields closely and time their purchases to spikes in yields, to eke out the best returns. We know that this is tough! So, we try to keep a close watch on market yields to alert you to good opportunities. We made our previous call to lock into high yielding long-term gilts and SDLs in July 2022. The call was timely. The 10 year yield corrected from that peak to hit 7.1% early this month. But it has been firming up again in the last couple of weeks.  

More interestingly, this time, interest rates on short term bonds have risen more sharply than those on long-term ones. So, we would like to use this recent spike to flag a good opportunity to invest in Government of India treasury bills, to park short term money. The rationale for this call is as below.

RBI actions

While yields on long-term government securities in the Indian market are influenced by many factors, the repo rate (the policy rate at which RBI lets banks borrow emergency money from it) carries a high influence over short-term market interest rates. Repo rate changes usually reflect in call money rates, commercial paper and short-term bonds issued by companies, certificates of deposit issued by banks and Government of India treasury bills. 

In its monetary policy meeting last week, the Monetary Policy Committee hiked India’s repo rate by 50 basis points for the third consecutive time. This has taken the repo rate up from just 4% in April 2022 to 5.9% now. When this rate hiking cycle started, much of the speculation was about whether RBI would even take up the repo rate to pre-Covid levels of 5.15%. Today, at 5.9% the repo rate is well above the pre-Covid level, signalling that MPC has reversed its Covid-related monetary easing and much more, to quell inflation. 

Investors in short term bonds today need to take a call on whether RBI is done with its hikes for now, or can hike further from 5.9%. RBI, unlike the US Fed, has refused to give any forward guidance on rates and they will be contingent on incoming data like inflation, the Rupee and the US Fed actions. But for now, the sharper-than-expected repo hikes have led to short term rates in the market, particularly on government bonds, moving faster than long-term rates.  The table below shows the extent of the upmove.

Liquidity withdrawal

Apart from MPC’s repo rate actions, short term interest rates in the market are influenced by how much excess liquidity bond market players like banks are sitting on. In recent months, with credit growth picking up to double digits, banks have had to deploy excess liquidity in lending. The RBI, meanwhile, has been relentlessly withdrawing the excess liquidity it infused into the bond markets, via banks, as Covid stimulus. 

RBI was among the rare global central banks to take quick action on withdrawing its Covid stimulus as soon as it saw signs of the economy normalising. RBI’s steady vacuuming up of excess liquidity is reflected in the outstanding under the LAF (liquidity adjustment facility) window falling sharply from Rs 7.58 lakh in the July-September quarter of 2021 to just Rs 26,152 crore in the same quarter this year. RBI’s withdrawal of easy money policies at a time when banks are also facing a scramble for funds, has been a second factor contributing to the sharp rise in short term market yields.

Rate differentials

Though the MPC’s policy actions are supposed to be driven only by domestic inflation and growth considerations, it is an open secret that the MPC also needs to keep a watchful eye on the rate actions of central banks in the advanced economies - particularly the US. When central banks in developed economies go on a rate hiking spree, triggering a fall in global bond and stock prices, institutional investors who have been pouring money into emerging markets like India get very jumpy and begin to rethink their risk-reward calls.

After all, when these large investors get high yields on US government bonds back home, why should they take on risks by investing in emerging market stocks and bonds, which can subject them to currency depreciation risks?  

As long the interest rate differentials between emerging markets like India and advanced ones like US remain wide, foreign investors are willing to pour money into Indian bonds, because they feel they are amply compensated for exchange rate risks. But when this differential shrinks, they usually get ready to stampede out of markets like India. 

This is the script that has been playing out since March this year, as the US Fed has hiked its Fed Funds Rate quite aggressively to quell inflation. The Fed Funds Rate (the US equivalent of repo) has soared from 0.25% in March to 3.25% now. With US inflation (8%) well above its comfort zone of 2%, the Fed isn’t done yet. It indicated in its September meeting that it expects to take the rate to 4.6% in 2023 before it takes its foot off the pedal. This means that FPIs investing in Indian bonds may continue to be in a risk-averse mode until then.  

Therefore, even if MPC/RBI want to stop or pause their rate hiking cycle because India has a better growth-inflation equation, they could be held hostage by the fear of FPIs withdrawing in response to the US Fed’s more aggressive rate hikes. With the yield on US one year government bonds moving up from 0.4% in January 2022 to 4.15% now, while Indian bond yields have moved up just from 4.4% to 6.7%, the US-India differential today is somewhat narrow for the FPIs’ comfort. This factor could force market yields in India upwards even if MPC follows a cautious path.

Government borrowings & index inclusion

All the above factors argue for India’s repo rate and short-term market interest rates to head higher from current levels. But there are two variables that may put a cap on such a rise. Short term interest rates in any bond market cannot acquire a life of their own beyond the rates on long-term securities. Long-term bonds in any market usually trade at higher yields than short term bonds to compensate for the higher risks that come with higher duration. 

Therefore, one of the factors that set limits to the current rise in India’s short-term bond yields is the outlook for long-term yields. Long term yields, which are reflected in the 10 year g-sec, usually respond to the demand and supply of central government paper. So far, the expectation that the central government will tap the market for record borrowings of Rs 14.3 lakh crore in FY23, based on the February Budget, was driving yields upwards.

But recently, buoyant tax revenues have prompted the Centre to temper down its borrowing target to Rs 14.2 lakh crore. After front ending its borrowings, the Centre plans to borrow only Rs 5.92 lakh crore in the October-March period, suggesting lower supply of bonds. 

A second factor that has made the 10-year bond gyrate in the last few months is the prospect of Indian g-secs being included in global bond indices such as the JP Morgan Emerging Market Sovereign Bond Index. High hopes of the inclusion coming through were dashed recently as JP Morgan refrained from adding India bonds and merely put them on a watchlist this week. India’s inclusion in global indices will add a large new category of buyers (global institutions and debt funds) for Indian government securities. As a result, news of an inclusion sees 10-year yields fall, while delays in the process trigger a rise in yields. 

Still, it does appear likely that Indian sovereign bonds will find a place in global indices sometime this year or the next, as Russia’s exclusion from such indices has created a vacancy for another large economy to find a toehold. The Indian government and central bank have also made less of a mess with the Covid stimulus and the fisc than many advanced economies. This suggests that 10-year yields may peak at 7.75-8% over the next few months. 

Given that differentials between India’s 364 T-bill (6.8% yield) and 10 year g-sec (7.4% yield) are already pretty narrow at 60 basis points, leading to a flattish yield curve, this will cap a rise in short-term yields. This makes it a good time for short term debt instruments.

T-Bills vs liquid funds, bank deposits & small savings

Today, government of India Treasury Bills of 91-day, 182-day and 364-day tenors offer higher yields than riskier instruments such as liquid funds, bank deposits and even small savings schemes of similar tenor. 

• Deposits with good banks today offer rates of 4.5%-5.5% for terms of 90-365 days. 
• Post office time deposits after recent revisions offer 5.5% on one-year time deposits. 
• While one would expect debt mutual fund categories such as liquid funds, ultra short funds and money market funds to reflect this rise in market yields, tracking their portfolio YTMs (yield to maturity) shows that this catch-up is yet to fully play out as the graph below shows. Investor returns in these funds going forward will be a function of the YTM net of expenses. 
• On the other hand, Government of India T-bills are offering yields of 6.2-6.8% for 3-month to 1-year tenors. Given that they are among the safest options in the bond market, they represent low hanging fruit for short term debt investors at this time.

Opportunities in T-bills

For tenures of 3 years and beyond, debt funds offer a distinct tax advantage over gilts. While interest received on gilts is taxed at your slab rate, long term capital gains on debt funds are taxed at 20% with indexation. 

But for shorter tenors, both gilt instruments and debt funds share the same tax treatment as short-term capital gains on debt funds are taxed at slab rates. Yes, YTMs on very short-duration debt funds could rise as the higher interest rates assimilate. But as things stand today, one might as well go by safety and known yield, which T-bills currently score on. 

Therefore, if you’re looking for short-term investment options, T-bills offer attractive opportunities at this time. Keep an eye on auctions by the RBI, and open an RBI Retail Direct account; these auctions are open only for a couple of days so it’s best to be prepped in advance. We will also alert you on such opportunities in our Prime Bonds recommendations (open to Growth subscribers only) as and when they come up. 

Do note that these T-bill opportunities are best used only if you require the proceeds in the short-term timeframe. If you’re investing for the long term, it’s best that you use a combination of short and longer duration debt funds.