BUDGET EXPECTATIONS : BOND MARKETS

21 Jan 2023 , 09:02 AM

It is often said that the bond markets are the step child in most budgets. The macros, corporates and equity markets get a lot of attention before, during and after the Union Budget. However, the Indian bond markets, despite being a $2.3 trillion market, does not get the same attention that equities and other asset classes get in the Union Budget. Here is what the bond markets expect from the Union Budget 2023-24.

Tempered outlook on fiscal deficit and borrowings

Why do these factors matter? For starters, the total borrowings are directly linked to the fiscal deficit; higher the fiscal deficit, higher the borrowings. In FY21 and FY22, the total government borrowings were to the tune of Rs12 trillion. However, in FY23, the total borrowings had spiked to $14.31 trillion. It may be recollected that the bond markets had come under pressure on the Union Budget day in year 2022 due to the sharp spike in borrowings. In addition, for FY24, the total borrowing target is expected to be around Rs16 trillion. However, the fiscal deficit is expected to be lower in the range of 5.8% to 6.0% of GDP. This is likely to temper some of the pressure on bond yields and on bond markets. The bond markets will expect a clear guidance on fiscal deficit and the borrowing program.

Leveraging on Sovereign Green Bonds

The sovereign green bonds announced in the previous budget are expected to be a success in the year FY23. The Budget 2023-24 is expected to be more aggressive on the issue of green bonds. Since, there are a number of mega environment-friendly projects that are being taken up at this juncture, a robust sovereign green bond market would help in raising funds as also for creating a secondary market for these green bonds. The budget offering special incentives to investors for sovereign green bonds can be a huge move for the debt and fixed income markets. In the Union Budget 2023-24, the government is expected to proactively bolster these markets and raise investor confidence. Since the cost of these green bond are lower, government can give guidance in the budget of a 5 year plan to gradually scale up the use of green bonds.

Special tax parity for debt funds

One of the major objections of investors has been that debt funds do not seem to get the same benefits and treatment as equity funds. For starters, debt funds have to be held for at least 36 months to qualify for long term capital gains, while equity funds have to be held for just 1 year. The tax rate even on short term gains on equity funds is much lower than the debt funds. Interestingly, the discrimination against debt funds is not just versus equity funds but also versus listed debt. For instance, in the case of listed bonds and debentures, they have to be held for just 12 months to qualify as long term capital gains. However, the debt mutual fund has to be held for 3 years to qualify as long term capital gains. In the last one year, the debt funds have seen a consistent fall in AUM share while the equity funds have seen a consistent rise in AUM share. A more rational tax policy with reference to debt mutual funds can encourage more flows into debt funds and can also boost debt fund participation in the bond markets. They are, after all, sophisticated institutional investors.

Offering investors the benefit DLSS funds

One thing that Budget 2023-24 is likely to do is to ensure that mutual funds play a much bigger role in the bond markets. The first is to encourage flows. The second is to allow new products. Currently, tax saving funds (ELSS) can either be active equity funds or passive equity funds. There are many conservative investors who want to get locked into debt funds for 3 years. However, in the absence of tax incentives, they are staying away. Instead, by offering a DLSS (debt linked savings schemes) akin to ELSS, the debt funds can attract a lot of retail money into these funds. As we have argued in the past also, the more the flows into the debt funds, the more meaningful role that these debt funds can play in making the bond markets robust and vibrant. These moves can catalyse aggressive participation by mutual funds in the debt market segment.

Clarity on inclusion in bond indices

It was a narrative that began with a lot of enthusiasm but fizzled out along the way. The plan in the previous budget was to make an aggressive pitch to get the Indian government bonds included in the liquid and popularly benchmarked JP Morgan Bond Index and the Bloomberg Bond Index. These indices drive a lot of passive bond index ETF flows into markets, since most of the global bond funds are benchmarked to these indices. However, the government did not offer the requisite tax incentives that the global funds had demanded and the decision was put off. Why is this significant? 

It is estimated that inclusion in the bond indices would bring in $30 billion of incremental flows into Indian government paper. That is nearly 50% of aggregate debt flows of in the last 5 years, so for the bond markets this is going to be a quantum leap. Clearly, the inclusion on the bond index will not only give a boost to flows, but the participation of global bond funds will also make the Indian bond markets much deeper and broader. However, for now, it is stuck on the issue of tax breaks on bonds to these foreign investors. The government must give a guidance on this front and it would actually add a lot of value to allow such tax breaks with a clear cut time frame. 

Bond markets need a clear trajectory on lowering inflation

Since most of the monetary levers for tweaking inflation are almost exhausted, the big challenge for the government is to use fiscal levers in the coming year. For the bond markets, the rate outlook and the willingness to support growth at all costs will be the key drivers of bond market sentiments. Normally bond markets look at two factors as cues in the budget; the outlook for inflation versus growth and level of government borrowings. Year 2022 was marked by persistent rate hikes of 2.25%, which has partially curtained inflation. Hence, a lot would depend on how the budget paints the colour of inflation for the coming year.

Budget must exorcise the ghosts of sovereign bonds

Sovereign bonds were an idea that came and then vanished. Union Budget 2019 announced plans to raise $10 billion via offshore sovereign bonds (government debt in foreign currency). That was dropped due to pressure of macro concerns amidst the pandemic. Government has been too conservative about sovereign debt in the past and it is time this budget gives up that conservatism. After all, with forex reserves at over $560 billion, India does have the leeway to go all out and aggressive raising money through sovereign bonds. It remains to be seen, how the government manoeuvres its borrowing program, but it is time for the Union Budget to give up its hesitation around sovereign bonds program.