Fiscal Worries May Weigh On Bond Market Despite RBI Support

The Budget proposal to boost liquidity in the corporate bond market received warm welcome but failed to wane the worries of fiscal deficit and inflation affecting economic growth. 

Finance Minister Nirmala Sitharaman on Monday proposed to set up an institutional framework that will purchase investment-grade debt securities to boost the bond market. 

“It is a positive move. Many debt funds have recently faced liquidity crunch and system-level liquidity infusion by the Reserve Bank of India (RBI) did not trickle down to needy borrowers,” says Pankaj Pathak, Fund Manager – Fixed Income at Quantum Mutual Fund. 

Market experts believe that the government has shaken the bond market by pegging the fiscal deficit at a level far higher than anticipated. Increased fiscal deficit in the current financial year at 9.5 per cent of the GDP and a target of 6.8 per cent for 2021-22 have left them surprised. They feel that the bond market will face heavy supply pressure not just in the current fiscal but also over the next few years.

“Concerns on growth, inflation and fiscal deficit would continue to weigh on sovereign bond yields despite RBI support. Also, even as credit upgrades-to-downgrades ratio seems to have bottomed out, it is still far from the long-term comfort level of around 1x,” says Rajesh Cheruvu, CIO at Validus Wealth. “Hence, we continue to remain focused on top quality corporate issuances / funds and short duration investments in debt portfolios.” 

Increased government spending for an extended period may also trigger inflationary impulse over the medium term, especially the tax proposals related to the introduction of new cess and import duties on various products can drive up inflation. For RBI, it would be a big challenge to support the government’s borrowing programme in case inflation rises.

“Investors should lower their returns expectation from fixed-income funds and follow a conservative approach while choosing fixed-income products. Interest rates are likely to move higher in the coming years. Long-duration funds may face high volatility in the coming months,” says Pathak.