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The gilt bubble bursts

Manas Chakravarty

In a depressing investment environment, debt funds had for long sustained us, giving decent returns at a time when the stock market had practically given up the ghost. That one bright spot on the investment horizon no longer exists.

Last month has been a traumatic period for the debt markets, with yields on government securities spiking up sharply. The ten-year government security, which had a yield of only 7.3 per cent on April 29th , went up to a high of 8.2 per cent, before settling at the current yields of around 7.6 per cent. The party is over for the debt funds.

Does that mean interest rates are on their way up again? For the period from April 19 to May 17, non-food credit increased by a humongous Rs 382.45 billion, compared to only about Rs 133.03 billion for the immediately preceding month. Won't higher credit offtake lower liquidity and push interest rates up? That may not happen.

First, the spike in non-food credit is abnormal, coming as it does at a time when credit demand usually slackens, and may be caused by higher borrowing from the oil companies. With the decision to raise prices and issue oil bonds, that problem has been taken care of.

Second, the Reserve Bank of India has said that it will take care of the liquidity needs of the bond markets, while at the same time ensuring that credit needs are met. The RBI has the leeway to meet that promise because inflation continues to be well under control.

But the gilts rally has been well and truly halted in its tracks. The Central bank has been able to effect a soft landing, and has taken unrealistic expectations out of the market.

Two other factors will inhibit any interest in the bond market. One of them is that the "war premium" hasn't been factored into the market, since yields today are lower than when they were before May 13, when the terrorist attack that led to the current escalation of tension took place.

The other reason is that corporates with cash to spare have forsaken the gilts market, instead choosing to park their funds in short-term deposits.

Now that the gilts bubble has burst, what is of interest to the investor is--- where will all the money that banks and companies put into gilts now go? My hunch is that it is unlikely to go into wholesale credit. One, companies still have plenty of excess capacity.

Two, large parts of our manufacturing sector are uncompetitive. Three, the fear of non-performing assets will continue to inhibit lending. Part of that money should therefore go into the best corporate bonds, reducing their spread over gilts.

But perhaps the incentives given for the housing sector, including a reduction in weighting for capital adequacy purposes, will ensure that banks continue to look at the retail housing market to drive their loan book. The overhang of unutilised housing too should end soon. The next bubble could well be in the housing sector.

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