India’s yield curve is steepening
Last updated: 15 Jun, 2020 | 04:13 pm
What is a yield curve?
The yield curve is a line that connects the returns that bonds in the country are offering for various time periods; i.e. from a few months to a few years.
A healthy yield curve is when yield in the short-term is lower than that in the long-term. It signifies a stable economy with interest rates and inflation steady where longer-term investors are compensated higher for locking in the capital for longer.
Find below India’s G-sec yield curve:
How is India Faring?
India’s yield curve is becoming steeper i.e. the difference between the short term yield (3M) and long term yield (10Y) is now at an extreme high of 2.38%. The yield spread (the difference between the 10-year yield and 3-month yield) has increased significantly from 1.03% to 2.38% in the last 1 year.
This may not be a good sign for the economy as this steepening is driven by a surge in interest rate cuts and a sharp fall in the short term yields in the last few months. These levels are generally a pre-cursor for the economy expected to go into a recessionary phase. Steepening of the curve when followed by an inversion is a precursor for a recession. The high long term yields are signifying inflation in the future which usually happens post an economic recession.
The 2008 economic slowdown saw a similar trend. The government had to reduce interest rates sharply to help the economy bounce back strong. What followed post-2009 was high inflation as the demand and government borrowing increased. The short term yields continued to increase at a brisk pace. The yield spread increased and thus flattening the curve.
Although the RBI is expected to cut interest rates by not more than 30-40 bps in the near future, with a piling debt and demand slowly coming back, we expect the inflation to rise in the next 3 years. The markets are normally first to react and will adjust as it sees economic growth and inflation come back- they have already started discounting the fact that we may be at the end of the cycle of RBI cutting short term rates (can be seen by an increasing difference between the 10-year and 3-month yields).
What does this mean for your investments?
- We expect the interest rates to increase and yield spread to decrease in the next 2-3 years.
- In an increasing interest rate environment, high duration funds, and long-maturity bonds tend to underperform compared to low duration funds and bonds.
- The yields are expected to remain extremely volatile in the near future. The effects will be more pronounced in longer duration bonds. You would see higher volatility in returns of your high duration funds compared to low duration ones.
We recommend you to shift your debt allocation to high credit quality low duration debt funds. They will outperform all your high duration funds in the next 3 years.
Have more questions? Click on the Ask Advisor button to connect with your family office to help you understand more about the current credit risk in the country and to help you rebalance your portfolio.