What should your bond strategy for 2022 be?
The calendar year began with a more decisive shift in the likely path of key rates for most global central banks. The narrative of “transitional inflation” has been widely dismissed by most central banks, with the policy focus shifting from the pandemic-induced emergency settings towards the fundamental goals of moderate inflation and macroeconomic stability. This led to a convergence of market expectations towards policy rate hikes by major central banks, alongside the rollback of quantitative easing (QE) programs. The impact of the same has been felt in the domestic bond markets, even though the policy guidance of the Reserve Bank of India (RBI) remains firm to foster growth. Meanwhile, in the last quarter, the RBI stopped adding primary liquidity and held frequent short-term reverse repo auctions to signal higher short-term rates.
With tighter global monetary policy as the base case, the outlook for Indian yields would depend on how the RBI tackles the difficult task of managing liquidity, controlling yields, moderating inflation and supporting the growth. Given the contrasting objectives and limited tools at his disposal, it is certain that this would lead to significant volatility and possibly potential sub-optimal results. In this context, one would expect that the main action would continue to be the modulation of liquidity with a possible objective of aligning overnight rates closer to the key repo rate. This would imply an active absorption of sustainable liquidity which would have an impact on returns.
In this context, it is interesting to note that RBI has recently resorted to selling open market operations (OMO) on the Open Market Negotiated Trading System (NDS OM) in small amounts since the last week of November. . Perhaps the provision of the Market Stabilization Program, if activated in the FY23 budget, could be a better market-friendly tool to absorb liquidity than OMO sales.
Key repo rates are expected to remain at 4% in the near term, given recent RBI policy guidance. However, as economic growth picks up, with the existing backdrop of a high wholesale price index (WPI) and consumer price index (CPI) sticking closer to the upper bound of the objective, the RBI will eventually have to revise the existing policy rate parameters. It is more likely to be a factor that could engage the markets in the second quarter and beyond. Positive data on public finances as well as probable measures to allow inclusion in the bond index could be positive triggers at the margin.
The dominant theme for the year will likely be the process of normalizing liquidity and monetary policy. A reassessment of market levels as well as bond spreads is inevitable as this process unfolds. This is more likely as the contingency policy and ultra-loose liquidity settings have continued well beyond the original timeline when such measures were necessitated due to the lockdown.
what you should do
From an investor’s perspective, this process, as it unfolds, would primarily require staying with a lower duration consistent with individual risk and liquidity requirements as well as asset allocations. A gradual reset in short-term rates as expected should correct the steep slope of the curve, improving carry while being exposed to lower duration risk. The market rate repricing phase should provide reasonable entry points for closed products and target maturity reduction strategies with a holding period matching the duration of the arrangement. Investment in variable rate products should ideally be aligned with a holding period corresponding to the rate normalization period.
The author is CIO – Fixed Income, SBI Mutual Fund.
The opinions expressed are personal.