September 20,2019 (MLN): This is a communal fact that when the market expects a cut in PIB rate, the asset prices go up i.e. stock, bonds etc. In a recent PIBs’ auction conducted on Wednesday, the cut-off yields in all tenors declined drastically by approximately 100 bps on average, indicating that the market expectations of early rate cut in FY20 is now on the cards.
Before going into details, it is pertinent to mention that the money markets incorporate the future interest rate expectation in the bond market which justifies the premium between Discount Rate (DR) & PIBs.
The economic comparison of 2003-04 versus 2018-19 in a research report by Shajar Capital reveals that despite having a market consensus over lower interest rate in 2003-04, the reality was against the expectations and the economic scenario changes with time amid higher imports leading to negative Current account balance in 2005. This led the currency to depreciate approximately 3.5% and interest rate increased by 150 bps in 2005 against the consensus made in 2003-04.
Similarly, the 10-year PIB again started trading at premium to DR in 2005, the report added.
The report further apprised that the current economic conditions are improving but the scenario is not that better than it was back in 2003-04. As double-digit inflation outlook and fiscal deficit remain a concern for the policy makers.
Therefore, market should not jump over a fixed longer-term bond at lower yields as there should be a stabilization period (10-20 months) in the economy before the interest rate starts to go towards a single digit, the report underscored.
Focusing on floating rate PIBs instead of fixed rate PIBs would reap healthy returns as things are getting better and interest rate will not come down to a single digit with in the next 12-months.
Thus, adopting a risk aversion strategy in the bond market for at least a year now and preference for floating rate bond which is currently providing a healthy return of over 14% instead of buying 10-year PIB at prevailing yield of a meagre 12%, is a prudent pick. Moreover, floater exhibited a better supply side, lower duration and limited interest rate risk of only 6 months.
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