On 15 May 2013, the export-import Bank of India issued 10-year maturity bonds at a yield of 7.94%. Why do we begin this article with details of this mundane bond issue? Because it is the lowest coupon we have seen in a 10-year corporate bond over half a decade. In the preceding month, corporate bonds and central government securities had one of their best rallies of all times. Bullish sentiment was so all-pervasive that by mid-May, there was not a single bear left in the market!
Fast forward to July 15, barely two months later, the RBI brought out the sledgehammer to defend the sharply depreciating rupee (incidentally, not one among the mainstream market experts forewarned us about the probability of RBI’s tightening measures in the face of the rupee’s weakness, even though this is very much a textbook response and had been resorted to succesfully in the past in the late 1990s). It sucked out the liquidity in the overnight money markets and resulted in a massive spike in a bond yields. By August 14, the Reuters benchmark for 10-year corporate bond rose to 9.76%.
At this rate, the above mentioned security would trade at Rs 89 (for Rs 100 Face Value) — a gut wrenching drop of about 11% in three months or an annualized negative return of about 40%.
This, in short has been the collateral damage to bond holders, including bank treasuries, insurance companies and other bond houses. As bonds are perceived as low risk assets, the fund allocation by institutions for bonds are always far higher than for equities. Hence, a 11% drop in value in a short time frame is of truly catastrophic proportions. Little surprise that most of our bankers are queuing up at the RBI’s doorstep looking for some forbearance in the valuation.
Why should this be of interest to you? Because a drop of this proportion also is a mouth watering investment opportunity.
To understand why, let us quickly rewind to the developments in the run-up to the current state of affairs. In the face of relentless pressure on the rupee, which dropped to almost Rs 65 by July 23, the RBI in consultation with the finance ministry decided to bring out its Brahmastra on July 15. It decided to make borrowing in the rupee costlier. In the first salvo, it raised the Marginal Standing Facility rate (the penal rate at which banks can borrow from RBI to 10.25% from 8.25%. It also limited the daily repo to 1% of net demand and term liability (NDTL, roughly the deposit base of individual banks). The idea was to increase the call-money rate closer to 10.25%. The rate however, fell to 8-8.50% levels within a couple of days of this move. This prompted the RBI to announce a fresh round of measures, which reduced the daily repo limit to 0.5% of NDTL and also made it mandatory for banks to maintain a minimum CRR at 99% on all days, in effect forcing the overnight rates above 10% in one stroke.
The stated objective was to chase speculators from the market. The logic being that speculators borrow rupees to buy dollars, to sell at a future date at a higher price. If the rupee's borrowing cost is increased to such an extent that it makes it risky for speculators to hold dollars, the incentive to speculate is neutralised. It also makes it costlier for importers to hedge too far into the future. Either way, this step is expected to provide respite to the rupee. There is also a bit of psychology at play here. An importer will hold back the purchase of dollars and a speculator will pause to think only if they perceive the rupee's weakness to be over, and will stabilize going forward. Hence, for the step to be effective, the RBI has to drive home the point that it is prepared to deploy everything in its arsenal to defend the rupee. If the message however is that the steps taken are temporary and will be withdrawn soon, the fear is diluted and so is the effectiveness of the steps taken.
The basic premise here is that there has been a massive speculative attack on the rupee. Data however indicates otherwise. By the finance minister’s own targets, there will be a current account deficit of at least $70 billion this financial year. In addition to which, there are reportedly $170 billion worth of external commercial borrowings (ECB) maturing before March 2014. Half of this liability is reportedly un-hedged. The assumption is that the maturing ECBs will be rolled over and hence, demand pressure from this source will not be significant. But, if I am the CFO of a healthy private sector business that has ECBs maturating this year, would I be interested in rolling over the loan with a forward cover for the rupee for one year at close to 9%? Or would I use a short-term domestic loan to repay and wait for a better time to borrow overseas? Not to mention the likely widening of credit spreads on account of the imminent tapering of the bond buying programme of the US Federal Reserve. One has to wait and see.
There are arguments which hold that the rupee has been over-valued on account of the inflation differential and, it held up so long only on account of portfolio flows. Hence, what we are experiencing is a long overdue adjustment.
From the behaviour of the rupee (at Rs 65 to a dollar currently) despite all the measures announced by the RBI and the government, it does appear as though the speculative component in the currency’s movement is not significant.
If the above is true then the interest rate measures announced so far would appear counterproductive.
The collateral damage done by these measures is huge. The bond market example is just the tip of the iceberg. There is serious damage being done to the real economy, which has already been slowing for many quarters now. The longer this goes on, the longer and more difficult it will be for a recovery.
There are two possible outcomes of the current RBI measures. One, the RBI succeeds and arrests the rupee’s devaluation or it fails and accepts a much lower level for the currency.
In addition to the two outcomes mentioned, there is a third probability, which is that of the central banker continuing with its policy for far longer and driving the economy into recession territory. The political cost of this outcome should rule it out.
In both probable cases, the aftermath will be the distress of the sharply slowing economy. Inflation is expected to be around 5-6% and, on account of the plentiful monsoon, food inflation is bound to be lower. This set up is ideal for the central banker to resume its rate-cut cycle. Even if the yields just drop to the pre-June 15 levels, we are talking of appealing returns in these difficult times. Ideally, a retail investor should look at gilt funds with a longer maturity profile for maximum bang for the buck.