The name is BOND !!!!!!!!!!!


While we continue to write on Indian equity markets (which are our forte) we have chosen a misnomer in the title nevertheless. In addition, we strongly believe in following what our mentors have preached. For instance, Peter Lynch maintained (albeit mockingly) that “people who trade bonds do not know what they are missing”.

This time, however, we are departing from writing about our favorite asset class – equities. We are writing about Indian BOND market. Also, we’ve not forgotten that over a “long term horizon and on average equities outperformed bonds most of the time”.

So why are we even thinking about them leave alone write and put forth a case. The point worthy of mention here is that equity markets outperform bonds on average and that there could be that occasional period where bonds outperform equities in the past and can happen in future as well.

Is this that time when bond markets will overtake the equities over a short time in the future?

Let us see. For starters, we know that these things do not happen only occasionally and the last time that happened in India was just 5 years ago. For records, Indian bond markets returned whopping 18% (this is not a typo) in 2003-2004 period as compared with 6-8% return from equities.

What could then be the ingredients of a bond market rally the?

  1. Plateau experienced in the rate environment (monetary policy of the central bank) after a rate tightening environment as a result of many MACRO factors (inflation etc.).
  2. View from the central bank that interest rate plateau is certainly choking growth (given inflation is under control) and there exists a scenario to decrease the rates to stimulate demand or growth.
  3. Existing bond paper would be much sought after as bond prices would rally as effects on interest rate stimulus will be only seen 2-3 quarters down in line.

    Are we then saying that now is the time to invest in bond markets and bond funds in particular?

    1. It looks like some of the ingredients mentioned above certainly could come through over the next few quarters. What could be the factors that would make this possible? Let’s see.
    2. For one, we are in an inflationary environment, with runaway prices on commodities (agro and otherwise), high fuel prices and resultant liquidity tightening by the central bank (the RBI).
    3. This would mean that if the situation continues for another couple of quarters then we could end up witnessing rate hikes, albeit modestly. This could in turn impact commercial lending rates and further slow down credit growth visibly(Banks are seeing these early omens – March 2008 Earnings). Another obvious impact of higher rate environment is on the corporate sector, by putting strain on the cash flows by way of higher interest bills each quarter(This could lead to rating agencies showing some concerns).

    What could be the impact on the GDP growth?

    Well, obviously pressurized corporate sector would borrow lower than before, postpone projects and concentrated on protecting the bottomline. This would visibly impact each one of us adversely. Slower GDP growth than witnessed over the past 3-5 years would not go down well with the government as well and this could be a trigger (There are sell side forecasts of low 6% range to optimistic 8% range).

    What would the government do?

    For starters, not much in an election year (2009) and therefore sacrifice growth over inflation control. But not for long, according to us. Which ever party heads the next government in 2009 will start to push reforms, provide more fiscal stimulus and look to push the GDP growth to same levels which we already saw, 9-10% real growth. The caveat in all this could be the government formation by a predominantly one party. Can that happen – lets see.

    So what?

    This means by mid-2009 we could witness the same situation we saw in late 2003. Rate cuts, loose monetary policy and ample liquidity. The impact of which will be favourable on the corporate sector and another equities rally. But not before late early 2010.

    Then what could be in store in the Bond markets by then?

    1. As a result of rate cuts, easy monetary policy in early-mid 2009 we could see bond market rally
    2. Investors would flock to Bond market as a result of weak prospects of performance in the equity markets in 2009 strengthening the rally
    3. Bond market could end up beating equities market by a whopping margin.

    Are there holes in this thesis?

Yes but not many.Firstly we could be wrong in purely timing the cycle (late 2008-2009).

Secondly, we do not know how the corporate sector could behave. For instance, if the corporate sector borrows from outside (ECB route- RBI may increase the limit of ECB) then the anticipated slow down will not pinch the GDP and equities would perform much better and RBI could increase rates further. We see this possibility unlikely, given the bottom of the rate cycle in the west.
And lastly, we could be very early on this prediction and therefore limit the returns from the bond markets.

However, the good part is that we have time on our side.

Until next time!

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