The evolving bond market and

its future outlook

 Bond prices are worth watching from day to day as a useful indicator of the direction
ofinterest rates and, more generally, future economic activity. Not incidentally, they're
animportant component of a well-managed and diversified investment portfolio.
Everybody knows that high-quality bonds are a relatively safe investment. But far fewer
understand how bond prices and yields work. Now that we have understood the basic
concepts about bonds, let's look at the inverse relationship between the bond prices and the
yield. The cash inflow for an investor in a bond includes the coupon payments and the
payment on maturity (which is the face value) of the bond. Thus, the price of the bond should
represent the total of the discounted value of each of these cash flows (such a total is called
the present value of the bond). The discount rate used for valuing the bond is generally higher
than the risk-free rate to cover additional risks such as default risk, liquidity risks, etc.

Bond Prices vs. Yield

Bond investors, like all investors, typically try to get the best return possible. To achieve this
goal, they generally need to keep tabs on the fluctuating costs of borrowing.
That's because the longer a bond's term to maturity is, the greater the risk is that there
could be future increases in inflation. That determines the current discount rate that is
required to calculate the bond's price. The credit quality, or the likelihood that a bond's
issuer will default, is also considered when determining the appropriate discount rate. The
lower the credit quality, the higher the yield and the lower the price. When inflation is
expected to increase, interest rates increase, as does the discount rate used to calculate
the bond's price increases. That makes the bond's price drop. The opposite will occur when
inflation expectations fall.

Duration of bond

The effect of interest rate risks on bond prices depends on many factors, but mainly on coupon
rates, maturity date, etc. Unlike in the case of zero-coupon bonds, where the cash flows are
only at the end, in the case of other bonds, the cash flows are through coupon payments and
the maturity payment. One needs to average out the time to maturity and time to various
coupon payments to find the effective maturity for a bond. The measure is called the duration
of bond.
 Growth of the Bond Market in India

In the 21st Century, the bond market outperformed the stock market. The bond markets have
grown at a CAGR of 14.68%, mainly in the government bond market as financial institutions
have been obliged to maintain a certain percentage of government securities to cater to the
smooth absorption of government bonds. RBI issued an auction issuing system for
government bonds in 1992. In the secondary markets, efforts were taken to increase liquidity
by regular issuance of 10-year benchmark securities and development of repo market,
introduction of transactions on interest rate futures and interest rate derivatives. In the last
two decades, the government bondholder share shifted from the majority by commercial
banks (from 70% to 40% share) to holdings by insurance companies (25%), Provident funds
(15%),RBI (15%) and FII and mutual funds (4%). Outstanding bond issuance in Government
securities comprises the maximum share with 75 Lakh Crore as of August 2021
 Government Policies

RBI gives retail investors direct access to the government bonds market

India will be the third nation in the world after the United States and Brazil, where retail
participants can take direct exposure to the government bond market.

The Reserve Bank of India on 5th Feb 2021 gave retail investors direct access to the
government securities markets – a move termed by Governor Shaktikanta Das as a “major
structural reform”.
Domestic investors, if tapped meaningfully, are potentially an inexhaustible source of funds
for the government when it is trying to borrow Rs 12 trillion from the markets in the next
financial year. This also widens the investor base even without compromising on existing
policies on domestic bond investment much.

The retail focus can also eventually shift to the corporate bond market and the debt market
in India can become as popular as the equities, experts say. In developed markets, bond
marketshave a larger volume than equities. (See the comparison between India and US Bond
Markets).

Sovereign bonds in India signal growing doubts on RBI's easy policy stance. The
yield on India’s benchmark 10-year bonds surged to its highest since April, while the
borrowing cost on Treasury bills rose to the highest in more than a year this week. That’s
asign that some investors are bringing forward bets for policy normalization by the Reserve
Bank of India after retail inflation recently crossed the central bank’s comfort zone of 2%-
6%.
The inflation shock is adding to uncertainty on whether the central bank would stick to its
pledge of keeping policy accommodative to support growth after the economy was battered
by a deadly wave of Covid-19 infections. RBI Governor Shaktikanta Das said “it’s too early,
it’s too premature” to discuss policy normalization at a review earlier this month.
 Indian VS US Bond Market

As a thumb rule, when the economy is expected to grow at a brisk pace, equity prices move
up and bond yields move up as well since the demand for money would be more, thereby
pushing up interest rates. Similarly, when the economy is sagging, bond yields come down as
demand for money is that much lower and interest rates ease accordingly. However, the
current developments in both US and Indian markets defy this convention. Let us look at
the market movements.
In the US, there was a ‘preparation phase’ for a long time, on the exit from exceptionally
low-interest rates that was administered in the wake of the Global Financial Crisis (GFC). The
‘exit’ started with the tapering and eventual withdrawal of the bond buyback program of
USD 85 billion per month, which was meant to inject liquidity into the system. Finally, from
in December 2015, the US Fed FOMC started raising signal interest rates. The overnight rate,
which was 0 per cent to 0.25 per cent at that point of time, was raised by 25 bps to 0.25 per
centto 0.5 per cent in December 2015. To date, they have raised rates by 1 per cent, bringing
the overnight rate to 1 per cent to 1.25per cent. It is expected that the US Fed will continue
hikingrates, rather than normalizing them because they are exiting from exceptionally low
rates, at an appropriate pace over the next couple of years.
In this situation, what do you expect? You would expect the US Treasury yield to move up,
right? Now listen to this: US Treasury yield is lower now than in December 2015 before the
initiation of the rate hike cycle. US Treasury 10-year yield is at 2.16per cent now (26 June
closing), lower than 2.2 per cent-2.25 per cent in December 2015. Puzzling? Former Fed
chairman Alan Greenspan used the term ‘conundrum’ for this kind of situation, which cannot
be explained by conventional logic. US equity markets are booming. The market does not
expect the economy to slow down, which may have required the US Fed to slow down rate
normalization. That is to say, given the buoyancy in the equity market, the US economy is not
expected to sag. The US Fed is expected to continue rate hikes at a pace appropriate for
them, but the US bond market is ignoring that aspect.
Now shift to India. The situation is somewhat comparable: the equity market is booming,
andbond yields are easing. There is an apparent dichotomy; if the economy is expected to
do well, the RBI may not need to cut rates to give an interest rate boost to the economy, and
 if the economy is not as buoyant, the equity market is probably going for a PE re-rating.
However, there is one fundamental difference between the developments in the US and
India:the RBI eased rates over the last 2.5 years and there is a possibility of further policy rate
cuts to a limited extent. Hence, there is the logic for bond yields to be on the lower side in
India.

Future Outlook of the Bond Market in India

On June 28, India’s Finance minister announced relief measures focused to broaden the scope
of credit guarantees, to mitigate the economic stress induced by the second COVID wave.
This is preferred by the government as a route to direct income support suggesting to stick to
its deficit target of 6.8% of GDP.

According to National Infrastructure Pipeline, in the next five years, India will require to raise
humongous amounts of capital to fulfil the INR 111 Lakh crore of investments for its
infrastructure build-out. A well-developed corporate bond market will be pivotal in financing
the infrastructure development and will also relieve banks from the long-term financing
problems.

Liquidity in the market can be fast-tracked by setting up of the institution to provide

secondary market liquidity to corporate bonds, developing the Limited Purpose Clearance
Corporation for corporate bond repos, and allowing corporate bonds as collateral under
theReserve Bank of India’s liquidity adjustment facility window

RBI’s announcement of the Government Security acquisition program for INR 1 trillion,
purchasing in the first quarter itself providing ad hoc support and increasing the uncertainty
premium on the bond market. This has improved the investor sentiment and the security
yields are likely to trade in a narrow range. Also, RBI shifting from a time-based to an
outcome-based policy provides them with credibility and flexibility to manoeuvre in difficult
times.
Attracting both domestic and foreign capital through exchange-traded funds and other
index-linked bond funds, which offer lower costs, more transparency, better liquidity and
potentialto build diversified portfolios.
References

• https://www.investopedia.com/articles/bonds/08/bond-market-basics.asp
• https://www.indianivesh.in/kb-blog/bond-market-in-india
• https://europe.pimco.com/en-eu/resources/education/everything-you-need-to-
know- about-bonds
• https://www.investopedia.com/articles/bonds/08/bond-market-basics.asp
• https://www.indianivesh.in/kb-blog/bond-market-in-india
• https://europe.pimco.com/en-eu/resources/education/everything-you-need-to-
know- about-bonds
• https://www.icmagroup.org/Regulatory-Policy-and-Market-
Practice/Secondary- Markets/bond-market-size/
• https://www.moneycontrol.com/news/opinion/how-india-and-us-bond-markets-
are- moving-and-lessons-for-investors-2319773.html
• https://www.capitalsurge.com/data/comparison-of-10-year-bond-yields-india-vs-usa/
• https://www.business-standard.com/article/finance/sovereign-bonds-in-
india-signal- growing-doubts-on-rbi-s-easy-policy-stance-
121061800145_1.html
• https://www.business-standard.com/article/economy-policy/rbi-keeps-
rates- unchanged-invites-retail-investors-directly-in-gilts-
121020501603_1.html
• https://www.crisil.com/en/home/newsroom/press-releases/2021/02/indian-
corporate- bond-market-can-double-by-2025.html