Factors impacting Liquidity, interest rates and Bond Portfolios in the Financial Markets

The article is to educate investors about the factors which influence debt security prices and based on market developments which debt products can be looked at for investments.

Debt is an important asset class where a mutual fund invests. There are pure debt oriented schemes, blended schemes-which have blend of both debt and equity in the portfolio, which have allocation of money to debt as an asset class. It becomes important for the investors to know which factors influence NAV( Net Asset Value) movement of debt schemes, so that they take informed decisions. Bond prices move in the opposite direction of change in domestic interest rates. Rising interest rates cause the bond prices to fall. Longer maturity bonds see sharper declines in price compared to short maturity bonds. Debt as an asset class is influenced by the liquidity in the financial markets.

Liquidity keeps on changing due to changes in following factors:-

• Inflation

• Money Supply

• Foreign Exchange Markets

• RBI Policies

• Credit Demand

• Government Borrowings

Due to changes in all the factors mentioned above, the interest rates change (When there is ample liquidity, interest rates go down and vice versa). When interest rates change, bond prices change which influence the Bond Fund Performance.

Bond prices get influenced by mainly 5 forces:-

• Inflation and Bond Prices

Inflation is the other factor that can affect the bond prices. Interest rates on bonds are supposed to be little higher than inflation. Hence, if the inflation moves up, the real rate of return one gets is not sufficient to even beat inflation. In such a scenario, interest rates move up, bond yields too move up and as a result of this, bond prices are likely to move down.

Inflation gets impacted by various factors like:-

• Money supply & Bond Prices

Money Supply can be measured at various levels. The most popular indicator of money supply is the M3 (also called broad money), which includes currency with the public, other deposits with RBI, demand deposits and time deposits. The growth in money supply increases the availability of money, thus increasing inflation. Excess money supply leads to fall in the interest rates. This sometimes, leads to overheating in certain sectors which get access to cheap money from banks, leading to increase in inflation. RBI however, checks the money supply through policy measures like increase in CRR (Cash Reserve Ratio) or SLR (Statutory Liquidity Ratio) requirements for the banks. These measures drain liquidity and over a period of time, help anchor inflation.

Consumer spending is important for a vibrant economy. However, if the spending rate is too high, it leads to higher levels of borrowings, increasing the money supply and thus pushing inflation upwards. This also can be checked through monetary measures like changes in CRR (Cash Reserve Ratio), SLR (Statutory Liquidity Ratio) or change in the policy rates. At the same time, if the consumer spending slows down, the growth suffers. Government, in such cases steps in with tax cuts, thus putting more money in the hands of people, expecting the spending to go up. A combination of the capacity build-up and the productivity levels together influence inflation. Over capacity and high productivity together would make more good available thus, keeping prices low. The reverse of this will put upward pressure on inflation.

• Demand and Supply Factors

The cost of money is the interest rate. Thus, the demand – supply equation is one of the major factors affecting the interest rates. The demand for money pushes up the interest rates and supply brings it down. Demand for money would be influenced by industrial activity, Government borrowing, capital investments and cross-border trade. Supply of money would be influenced by foreign exchange inflows in form of portfolio investments or FDI, Government borrowings, household savings, Reserve Bank’s monetary policy through monetary measures and industrial productivity.

• Foreign Exchange Rates and Debt Prices

The foreign exchange rates get influenced by inflation in key countries as compared to India, structural imbalances across various geographies, money supply within and outside the economy. The exchange rate, domestic interest rates and inflation are considered to be interlinked. World stock market position has the potential to rapidly change the direction of portfolio investments, which inevitably puts pressure on the exchange rates. Finally India, being net importer of oil, is highly vulnerable to the changes in petroleum prices. Commodity price movement in international markets also affect inflation in India as some manufactured items in India, also procure raw material from outside , the prices of which is governed in international markets. If input prices go up, the end product prices also go up in the market causing inflation to go up on one hand and high import bill on the other hand. Costlier imports lead to increase in trade deficit, which widens fiscal deficit. Higher fiscal deficit leads to increased government borrowings and this leads to increase in interest rates and fall in bond prices as the two are inversely related.

• Government Borrowings and Debt Prices

This is directly related to Fiscal position of the government. If the expenditure of government goes up and its revenues dip, fiscal deficit widens.

This deficit is funded by the government by borrowings in the debt market. If the borrowing increases, excess supply of government bonds leads to fall in the prices of the bonds , which leads to increase in yields. Approximately 85% of the borrowings in debt markets is by Central Government & State governments put together and therefore how much government borrows from the debt market every week, starting from April of the financial year through to March of the next year, influences debt prices as liquidity gets absorbed due to high borrowing which leads to interest rates going up.

• Credit Growth

If credit growth picks up, industrial activity picks up and that results in higher growth numbers. This however, is dependent on the rates at which banking sector funds Industry, Agriculture and Services Sector. This , in turn is subject to availability of liquidity with banks. If liquidity is high, interest rates go down and funding of projects happen at low rates. Cost of funds go down and industrial activities pick up, which lead to employment generation, more income in the hands of consumers and increased spending by them.

In the present scenario, interest rates have an upward bias, due to change in liquidity position in the markets due to above factors. In such a scenario, the investors can look at parking their investments in low volatility debt portfolios. In these portfolios, the funds deploy money in short term debt papers , which currently offer better accruals and make the portfolio a low volatility portfolio. Liquid Funds, Ultra short funds and Short Term Plans make good investment avenue for risk averse investors who wish to park monies for short term investment horizon. Please also consult your financial planner to suggest good funds in these categories to you.

Source: ICICI Mutual Fund.