Caution – 2018: A Red Flag for financial Investors

Can the honeymoon period of investors end in FY18? With Sensex and Nifty rallying, all time high upto 35000points and 10800points at the end of 2017; investors have surely gone bananas over the above average returns on their portfolios. But one should also take note that the year 2017 has given us an unprecedented amount of new highs in the financial market. Whether it is in the inflow of mutual funds or FDI investments in equity market or cryptocurrency, the thread of current trends has surely beaten the historical years.

"Stock markets are the wings for many aggressive investors and Fixed Deposit have been the cashcow for many risk adverse investors but government securities are the gold mine for banks in our economy".

Government Bond markets in India holds an interesting story to narrate all investors. The empirical research into the bond and FD market has found a strong revelation on the performance and trends in our Economy. The year 2006 and 2017 had very similar characteristics in the given markets. Factors such as an increase in fiscal deficit and government borrowing rise in crude oil price and then inflation.

The rise in bond yield has surely struck many institutions and is now at precarious levels. Our research has shown us a massive red flag, as the spread between the government bond yield and Fixed Deposits at banks is at the highest level in last 15 years.
But one may ask why Government securities’ yields are greater than Fixed Deposits- is it a great deal for the investors or the economy? Or a newbie may say, shouldn’t current rise in Government securities-yield predict a great outlook for bond traders and foreign banks? Surely it is, and I concede with neophyte premise in this scenario but the events that unfolded after FY2006 can answer few of our uncertainty. We think 2017 has an eerie similarity to 2006.
Let’s look into events that took place both in FY06 and FY17:    

2006

    Market Size

o  Merger and acquisition volume was a record $27.8bn, up 38 percent, driven by a 371 percent increase in outbound acquisitions exceeding for the first time inbound deal  volumes
o  Debt issuance reached an all-time high of $13.7bn, up 28 percent from 2005
o  The Indian mutual fund industry grew 58 percent, from Rs 2, 07,979 crores (Rs 2079.79 billion) in January to Rs 3,29,162 crore (Rs 3291.62 billion) in November 2006. Debt funds continued their slump on account of volatile interest rates and returned 4.7 percent on an average.

2017  

    Market Size

o    Total Merger and Acquisition (M&A) activity rose 23 percent to US$ 15.8 billion.
o    Debt issuance reached an all-time high of 6.8trillion in 2017.
o    Domestic mutual fund (MF) industry's Assets Under Management (AUM) touched a record high of Rs 20.06 lakh crore (US$ 313.06 billion).

Players and Significance

The significance of above facts and figures shall become clear once we underscore the players and their payoff in the bond market. The Indian government bonds have two types of buyers and sellers, one that is Foreign banks and primary dealers and other is the National banks which legally hold 70% share of government bonds market. Since the rule set in ordinance with RBI, national banks are mandated to invest 20.5% or more of their net demand and time liability in government bonds. Other players that buy government bonds are Insurance companies, provident funds, pension funds, mutual funds, primary dealers and cooperative banks.

Why Banks Might Fall 

In a recent speech by the ministry of finance to curb fiscal deficit, Finance minister has publicly announced to borrow 5000 crores to cover the shortfall in collection of Goods and service tax by selling sovereign bonds in late 2017. And with the rise in crude oil price, RBI has adopted a more hawkish strategy in their monetary policy to stabilize the economy. However, the current trend in a loophole of strategy can be dated back to the FY2006. In process of our extensive economic analysis, we could predict the cyclic event that might happen in FY2018. In the below diagram, we can clearly see that in 2006 3rd quarter, the average difference between bond yield and the Fixed Deposit was around 1.01% which remarkably was a highest unprecedented difference in past 5-10 years. However, coincidently after 10 years, 2017 4th quarter showed the same average difference of 1.01% between bond yield and Fixed Deposit rate.

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This difference itself should make investors wary of possible risk in the future economic event. However, to elaborate further, we can also see that the Rbi kept on increasing repo rate from 7% to 9% through 3rd quarter 2006 till 3rd quarter 2008 after which it reversed its stance of increasing the repo rate and started decreasing it.

Additionally, the inflation rate rose to about 6.4% in September 2006 from 3.63% in September 2005. A rise in interest rate was a corollary to rise in inflation rate.  However, leading to this rate increase there to elaborate further, we can also see that the Rbi kept on increasing repo rate from 7 % to 9 % through 3rd quarter 2006 till 3rd quarter 2008 after which it reversed its stance of increasing the repo rate and started decreasing it. However, his difference itself should make investors wary of possible risk in the future economic event. were a tremendous amount of repo rate cut before the years 2006, as RBI thought the economy was running stable and a demand led price surge is unlikely. But rise in crude oil prices in the 3rd quarter of 2006 which rose to about 21.7% YOY was an unlikely event for Government bond yield and which in turn hurt the portfolio of the national banks.  In addition, government borrowing also led bank rates to fall giving a hard time for Fixed Deposit holder. Similarly, in 2017 inflation rose to about 5.21% in December 2017 from 3.41% in December 2016. And the price of crude oil increased to about 14% in 4th quarter 2017 YOY.

            But, the most staggering fact that caught our attention is that even though Inflation is rising and banks are seeing increasing NPA’s, RBI has been cutting repo rate from 6.75% to 6% in 2017. Theoretically, RBI cuts rate when it thinks that economy is stable and balance of payments situation of the country is seen to be stable by the bank. Since the yield rate has been rising, the price of bonds held by banks have fallen, therefore, now banks sit on staggering losses of 10.2% in last one year. With rising NPAs, banks by default are more burdensome to withstand this exacerbating loss in their portfolio.

Conclusion

To conclude, even though RBI has been cutting repo rate, our analysis shows that RBI will have to increase its repo rate in future otherwise India could go into serious turmoil between safe and risky assets. Banks already have to finance the deficit in their portfolio due to price fall in bond market and this will eventually hit the banks’ balance sheets till they find the optimal strategy to tackle the bond price fall. With growing inflation and rising Crude oil price, Interest rate increase is inevitable in the near future and Bond yields will rise until the Government responds to it with effective cushions and strategy.

And for all you investors who are looking forward for options to invest, and where all the money is drifting away, our second report will showcase some curious cases. For now we recommend staying away from gilt Mutual funds and Fixed Deposits of longer duration as interest rates are going to rise.

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                       Mudrkash and Mcshaw Asset Management Analytics


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