Cash crunch hurts short-term debt

Tight liquidity has distorted returns in the fixed income market. Investments in short maturity fixed income securities have had negative returns while investments in long-dated fixed income securities have shown handsome gains.

Over the last fortnight, yields on ten-year government bonds have come down from 8.40% to 8.20% due to hopes of rate cuts and of government bond purchases by the central bank. Falling inflation (down from 9.11% in November to 7.47% in December), coupled with expectation of lower GDP growth of 7% in 2011-12 against 8.6% in 2010-11, will prompt the RBI to ease its policy stance on Tuesday. The RBI has also been buying government bonds through Open Market Operations (OMO) purchase auctions to boost liquidity, leading to increased demand for government bonds in the market.

The fall in government bond yields is not reflected in yields on both money market instruments and corporate bonds. One-year bank Certificate of Deposit (CD) yields have gone up by 30 basis points (bps) over the last fortnight, while two-year corporate bond yields have gone up by 11bps. Five-year corporate bond yields have been steady, and have not reflected the drop in government bond yields, while ten-year corporate bond yields have dropped by 10 bps over the last fortnight.

The reason is, liquidity (as measured by bids for repo in the Liquidity Adjustment Facility  -LAF - auction of the RBI) has tightened by around `60,000 crore since the beginning of January 2012. Tight liquidity conditions are pushing up rates at the short end of the yield curve, as the market is forced to sell or postpone buying short maturity bonds. Higher supply, coupled with lack of demand, is pushing up yields on money market securities and short maturity corporate bonds.

What are the implications for fixed income investors? The fall in yields on longer dated fixed income securities will benefit investors in long maturity bonds or long-term gilt or bond funds as higher prices lead to capital gains. Investors in short maturity bonds or short-term bond funds could experience loss of capital or extremely low returns due to the rise in yields. The concept of lower risk due to lower maturity fails here.

Investors who want to take advantage of falling interest rates, should invest in long-term gilt or bond funds when the outlook for liquidity is negative. If it is positive, however, investments in short-term fixed income instruments would be lucrative, as yields will fall as liquidity improves.

The outlook is negative at present; so investments in long-term fixed income instruments will pay more than those in short-term fixed income instruments. March 2012 is the right time to invest in short maturity bonds or bond funds, as liquidity will be tight due to fiscal year-end pressures and yields on short dated securities will be at their highs. Good liquidity will return to the system in April and yields on short-dated securities will fall, leading to capital gains.

The writer is the editor of  www.investorsareidiots.com,
a website for investors