Posted in Finance Articles, Total Reads: 1030
, Published on 25 March 2015
The recent trend in the 10-year GoI and a basic understanding of how it convinced the RBI to implement the long-awaited rate-cut
The rate cut by the RBI made the headlines and was touted by many as a “surprise”. What caused the RBI to act prior to the date expected by the market participants? This article tries to answer this and a few other related questions.
Before we proceed further, we will quickly go through a few terms related to bond instruments:
1. Face Value or Maturity Value – The principal amount underlying the instrument (usually ₹100 or ₹1000)
2. Coupon – The annual/semi-annual interest payment made to the bondholder. It is usually fixed (though floating-rate bonds are also available). For instance, if the coupon rate is 6% on a bond with a face value of ₹100, the bondholder gets paid an interest of ₹6 at the end of each year. At the end of the final year, he gets the interest as well as the principal making it a total of ₹106.
3. Yield – The rate of interest that the investor will lock in if he buys the bond at that particular time and holds it till maturity. Usually, most investors might not buy long-term bonds during the initial auction and hold them till maturity. Investors purchase and sell bonds at various stages of the life of the bond. This exposes them to the variation in the market interest rates. If a new issue comes to the market and the coupon rate is equal to the market interest rate at the time of issue, an investor can lock in the coupon rate if he holds the bond till maturity. Unless he chooses to sell the bond, he is immune to the movement of the market interest rate. However, this poses a significant liquidity risk since the investor’s money would be stuck up for a long time. Hence, the movement of the 10-year GoI is of crucial importance to bond investors.
The 10-year GoI is the yield on the 10-year bond of the govt. of India. On the other hand, the repo rate (or the repurchase rate) is the rate set by the RBI for overnight/short-term lending. The RBI controls the repo rate. However, the RBI doesn’t have direct control over the 10-year GoI. The 10-year GoI is determined by market factors.
Now, we come to the relation between the repo rate and the 10-year GoI. They are basically two constituents of what is known as the term structure of interest rates or the yield curve. The yield curve defines the relationship between bond yields and different maturities. The yield curve reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions. I’ll try to illustrate this with an example:
Let’s say the current rate for 1 year is 8% and the expected 1-year rate 1 year from now is x%. Let’s assume the current 2-year rate to be y%. Now, an investor should be indifferent between investing for two years today or investing for one year today and then re-investing for one year after one year. (Assuming negligible transaction costs incurred in attempting to re-invest). Therefore, we have:
(1.08)(1+x) = (1+y)^2
From the above equation, we can see that if x>8%, y>8% follows. Similarly, if x<8%, y<8% follows. This exercise can be repeated for 3, 4, 5 years and so on to obtain the yield curve over a variety of maturities. If future short-term rates are expected to increase, the yield curve is upward sloping. The reverse is true if short-term rates are expected to fall. This theory is called the pure expectations theory where the yield curve is determined solely by investor expectations.
However, investors usually expect a premium for investing in long-term bonds due to their exposure to the market interest rate fluctuations and the liquidity risk (both have already been discussed above). This usually results in the yield curve for an economy being upward-sloping (liquidity preference theory). However, if a downward sloping yield curve is encountered despite this, it indicates an extremely strong market expectation that short term rates are going to fall. This is exactly what happened in India since around October 2014.
For about 1 year prior to October 2014, the 10-year GoI kept fluctuating between 8.5% and 9%. However, by 14th January 2015, the day before the official announcement of the rate cut, the 10-year GoI closed at 7.77%, which was well below the prevailing repo rate of 8%. This had meant that investors were faced with a downward sloping yield curve. As discussed above, this indicated strong investor sentiment regarding a rate cut.
At this point, it is interesting to note that the 10-year GoI fell below 8% (the repo rate) for the first time on 2nd December 2014, which is well before the actual RBI announcement. As this point Raghuram Rajan had not made any public statements with regards the possibility of a rate cut any time soon. However, the movement in the 10-year GoI meant that companies could borrow from the market at a rate lesser than what they would have to pay a bank for a term loan. I will try to explain this using the following example:
A regular commercial bank typically lends at a rate that is greater than or equal to the base rate. The base rate is the minimum rate of interest that a commercial bank has to charge its borrowers except in cases allowed by RBI. This rate is usually around 200 basis points (or 2%) above the repo rate. However, in India, borrowers prefer banks due to the corporate bond market being heavily regulated. However, with the 10-year GoI falling below the repo rate, it became much cheaper for firms to borrow from the open market. For instance, if the 10-year GoI is 7.8%, investors will charge a spread over that figure as compared to commercial banks charging a spread over the base rate which was hovering around 10% for most banks.
Basically, this meant that the effective rate of borrowing in the market was actually going down despite the RBI’s stance on maintaining the existing repo rate. But why was the RBI insistent on maintaining the repo rate? The reason was inflation. RBI was insistent on curbing inflation before it implemented a rate cut. If a rate cut is implemented, its main goal is to stimulate consumption as well as investment resulting in an increase in aggregate demand. However, one of the effects of increased aggregate demand would be an increase in the price level. As seen from the following figures, the global oil price fall is what caused inflation targets of the RBI to be achieved before what was initially expected.
The correlation between the falls in both the statistics since July/Aug 2014 is quite evident. This was the main reason behind RBIs rate cut. Please note that the recent rise in the inflation figure is due to something termed the base effect. It is basically the consequence of abnormally high or low levels of inflation in a previous month distorting inflation numbers for the most recent month. An illustration is as follows:
Inflation is calculated from a base year in which a price index is assigned the number 100. For example, if the price index in 2010 was 100 and the price index in 2011 rose to 110, the inflation rate would be 10%. If the price index rose to 115 in 2012, what would be the best way to assess inflation? On the one hand, prices have only risen 5% over the previous year, but they've risen 15% since 2010. The high inflation rate in 2011 makes the inflation rate in 2012 look relatively small and doesn't really provide an accurate picture of the level of price increases consumers are experiencing. This distortion is the base effect.
Before closing, it is interesting to note that a downward sloped yield curve can be damaging to the economy if it persisted over the long run. Investors would prefer to invest in the short term thus causing a shortage of funds that could be loaned out to businesses in the form of long-term loans. This would affect the real GDP of the country since sectors like infrastructure, energy, and others that are dependent on long–term funds, would take a hit.
This article has been authored by Sandipan Dutta from IIM Calcutta