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The yield curve - Views on News from Equitymaster
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  • Aug 18, 2001

    The yield curve

    In the previous article we had taken up some measures that quantify the returns on debt instruments. Going further we look into some of the factors that affect the pricing or the valuations of the debt instruments. (Kindly note the debt instruments considered in the article are G-secs and T-bills. Other instruments like debentures and zero coupon bonds are not included. )

    The very purpose of understanding the factors affecting the yield is to be able to correlate what effect the change in these factors would bear on the price of the instruments. We begin this exercise by looking at a very important graph. This is a plot of the yield (YTM) on various debt instruments against the time to maturity. This is known as the yield curve. Under normal circumstances, bonds with longer time to maturity will offer a greater return as there is a far greater element of uncertainty and therefore, risk (high risk-high return). And of course the instruments of a shorter duration will offer lower returns. Thus, the yield curve is in a normal course of events upward sloping.

    Fortnightly closing YTM for benchmark securities (16th July 2001 to 31st July 2001)
    Source: Debt to Date,SHCIL,Issue no.14

    However, the yield curveís slope changes as various factors affect the pricing of debt market instruments. The curve might become flat or even slope negatively. A negatively sloping yield curve indicates that the short-term instruments are priced lower than those with longer duration to maturity. Therefore, the yield curve could give an indication about, which instruments are attractive and which are not in a particular market environment.

    Understanding the forces that shape the yield curve, investors can make qualified decisions in selecting bonds with maturities so as to get an optimal return under different environment. For example take a yield curve that is flat instead of the normal upward sloping curve. In such a scenario, if you were confident that normalcy would return to the markets, you should sell long-term bonds and buy short-term bonds.

    The monetary policy
    The government borrows money by issuing G-Secs (longer duration) and T-bills. The interest the government pays on short-term instruments is the benchmark for all financial activity in the country (this rate is considered to be close to risk free). After the rate cut in March the benchmark interest rate in India is 7%.

    Suppose the Reserve Bank feels that there is too much liquidity in the financial system and there is a threat that inflation may rise. In such a scenario the Reserve Bank will adopt a tight monetary policy. It therefore sells government bonds (and collects money), reducing the money availability in the system. In case the central bank wants to ease the monetary policy, it buys back the bonds, in effect infusing liquidity in the economy.

    The central bank can therefore effectively control the short-term interest rates and the lower end of the yield curve. When the markets expect the central bank to cut rates the short-term instruments become expensive as they continue to offer higher interest or coupon rates. Consequently, the yield declines, adjusting to the lower interest rate environment (the yield curve steepens). On the contrary when the expectations are that the central bank will increase interest rates the price of the debt instruments fall causing the yield to increase (the yield curve flattens).

    The central bankís decision to cut interest rates or to increase it also depends on the economic scenario in the country. The central bank has to keep in mind two objectives - to promote economic growth and to keep inflation under control. If the growth prospects of the economy are good then investment activity will be buoyant, resulting in demand for money (to fund expansion). However, unchecked investment activity could lead to a heating up of the economy, giving rise to inflationary pressures. In such a scenario, the central bank needs to adjust the fast rise in demand to the slower growth in supply. The central bank does this by increasing the cost of money. When the cost of money is high, both investment and consumption demand suffer.

    Economic growth
    Economic growth and its prospects affect the yield curve. This is because the monetary policy is largely influenced by the health of the economy.

    The growth prospects of the economy affect the allocation of capital. If there are little or no growth prospects, the demand for capital will be sluggish. Banks would be saddled with surplus funds, which would probably diverted to the debt markets. Also, in a slowing economy, banks themselves might not be comfortable giving loans to the industry for fear of accumulating bad debts. Consequently, the investment avenue that guarantees almost risk free returns is the G-secs and T-bills. This drives up demand for debt instruments. Higher demand results in prices of debt instruments being marked up, implying that yields decline.

    On the other hand, when the growth prospects for the economy become brighter the demand for these instruments weakens.

    Fiscal policy
    The fiscal policy controls the governmentís earnings and spending. If a government spends more than it earns it will incur a fiscal deficit. A higher fiscal deficit increases the risk of default by a government. Therefore, the interest rates in these countries are higher. Rising budget deficits cause the yield curve to be steep while falling budget deficits tend to flatten the curve.

    India Incís balance sheet

    However, in case a fiscal situation of a country looks precarious the short-term interest rates will tend to be much higher than long-term interest rates. The long-term interest rates will be relatively lower on hopes that the situation improves in the future.

    But if the fiscal deficit continues to rise then interest rates in the long term will be higher because the government will continue to borrow to meet its fiscal deficit, increasing the demand for money. The markets as a result would demand higher interest rates causing the prices for instruments to decline.

    Inflation affects both the long term and the short term yields. If the inflation is around 7% and the long-term yield is about 11%, the real rate of return is just 4%. Therefore, if inflation rises the real rate of return would decline causing the price of the instrument to head south and thereby increasing the yield. This causes the yield curve to flatten.

    Attractiveness of debt markets
    The investors who have invested in the stock markets have gone through a bad phase considering that firstly there was the tech meltdown and then of course the scams that were unearthed. Also, with the badla system being banned the investors have only one avenue left where they can get almost risk free returns this has caused the demand for the debt instruments and therefore their prices to move up. However, it remains to be seen whether the demand is more of short-term instrument or for long-term instruments.

    In the first quarter of FY02, the gross fiscal deficit at Rs 422 bn was almost double compared to Rs 251 bn in the corresponding period in the previous year. The increase in fiscal deficit was due to over 40% drop in revenue receipts. The decline in revenue receipts was caused by a 54% dip in corporate tax collections, which was on account of lower earnings by corporates. This clearly points to the slowing economy. Also, the actual expenditure of the government at Rs 651 bn was higher by 14% compared to 1QFY01.

    The present scenario is one of uncertainty. In such an environment, the Ďassured returnsí of government securities may make investment sense. However, one must take a broader view in terms of the overall asset allocation before making a commitment to any one-asset class.

    In the next article we will deal with how to invest in the debt markets.



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