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Bonds attractive option if banks cut rates

Depositors sure would not want banks to cut rates when there’s uncertainty over inflation as returns could turn negative if the rate inches upwards from the current 5.1% level.

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It is quite intriguing to note, when the Reserve Bank of India cut repo rate by 25 basis points to 7.75% on January 15th this year, the equity markets were jubilant with Nifty ending the day sharply up by 216.60 points to 8494.15 (2.62% up). When it did a repeat on March 4th to 7.5%, the reverse happened – Nifty moved in a wide volatile range of 8893.95-9119.20 before closing in the red by 73.60 points to 8922.65 or 0.82% lower from the previous close.

What do the two episodes convey to retail investors?
 

The latter happened after the government hiked diesel and petrol prices on March 1 by over Rs three a litre which are inflationary by nature as transport costs soar. Second, the unprecedented rains we witnessed in the first week of March is reportedly said to have destroyed rabi crops to a great extent. Going by unofficial estimates, wheat, barley, sesame, peas and mustard are likely to see a drop of at least 20% in their outputs over the previous year.

Depositors sure would not want banks to cut rates when there’s uncertainty over inflation as returns could turn negative if the rate inches upwards from the current 5.1% level.

Banks on the other hand also would not want to cut deposit nor lending rates in the immediate future due to this uncertainty. They are still struggling with deposit growth of 11-12% as against the 15-16% growth seen during a robust growth phase a few years ago. Even the finance minister, Arun Jaitley has admitted that the country's savings over the last three years have come off its peak of 36% to now 29%. Where does that leave retail investors now when inflation is eroding savings?

What does a repo rate cut mean to the common man? It is nothing but a cheaper rate at which RBI lends to banks against government bonds to lower banks’ borrowing costs through deposits at 8.5-8.75%. For retail investors, it is important to know that repo cuts usually signal lower rates, but banks are in no hurry to lower them as they would prefer using cheap money for lending to selective triple `A' clients.

Lower interest rates, under the present circumstances are beneficial to borrowers – individuals as well as corporates – but certainly not for savers when upward pressure on inflation looms large. Already prices of vegetables have witnessed a pick-up post the unseasonal rains we recently witnessed and of course the hike in fuel prices on March 1. This week, the inflation data numbers are expected to be upward of 5.4%. But why did the RBI cut the key rate? The only plausible reason could be that inflation numbers were well within its March 31 target of 6%. But then what after that?

A series of events in June and the monsoon estimates are key factors that will decide the direction of rate movements. The RBI has been vocal that it would decide the course on rate cuts based on data.

If US Fed hikes rates, there could be an outflow of foreign funds from the Indian bond market to US. This could lead to the rupee gaining, may be sharply which in turn could pressure domestic rates upward. Even worse will be the case if monsoon is not up to the weatherman's expectation, which implies higher inflation. Global crude will be another contributing factor to rates if there is a reversal in trend.

For argument sake, if US hikes rates when India is on a rate-lowering spree, then Indian bonds cease to be attractive to foreign institutional investors due to narrowing rate differentials and preference over a stable dollar than a fluctuating Indian currency. In other words glut of papers mean rising yields or an upward pressure on domestic interest rates.

The options before conservative retail investors are neither equities nor commodities like gold which is on a losing ground since Jan 23. From $1294/oz it has fallen to $1171.50 on March 9. Whether the metal has reached a bottom to buy is not yet evident. That leaves fixed income papers like corporate and government bonds as safer havens.

The best benchmark for retail investors to compare average bank deposit rates of 8.5% is with government bond yields. Ten year maturing bonds in the secondary markets, after factoring in inflation still gives a return of around 7.75%, much above the present inflation rate. The yields in the secondary market have not adjusted to the RBI's new repo rate of 7.5%, indicating that the markets are behaving contrary to the central banker's view.

Even the 180-day treasury bills yield better returns of 8.2% as against a similar period bank deposit rate of 8%. Another major factor to consider investing in government bonds is that if interest rates go down, investors stand to gain by way of price appreciation of the bonds.

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