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Economy

Money’s getting expensive, and fast, and what you can do about it

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The debt markets are cowering in fear. On 08 March, the 1 year government T-Bill auction yielded 7.46%. In terms that normal human beings can understand:

The government has to pay 7.46% to borrow money for 1 year.

This, in itself, sound harmless. So what, you think? Well, this this is the second highest rate since 2015. The last “high” in 2018 was 7.73%, just a little bit higher than where we are right now. And it impacts a lot of things.

TBill Auctions

What, really, does it impact? Technically every single corporate borrower should pay a higher rate than that. The government has guns, and can print money. Which means it’s the safest thing to invest in, for a rupee investor. If the safest thing pays 7.46%, any Indian corporate has to pay more.

Plus, remember that the government’s largest expense is interest payments. It ruins the fiscal deficit if they have to pay more, and we will pay for that – either with higher taxes, or higher inflation. All in all, not good.

But theres’s one positive – with inflation at 6.5%, we are actually in “positive” rate territory. Meaning, your money can grow at faster than the rate by which its purchasing power declines. Times like this don’t come often.

And then, there’s this little Covid thing

A strange thing will change the debt markets. Because of what happened three years ago.

Three years ago, in 2020, Covid struck, or at least threatened to strike India. This caused massive lockdowns, offices shutting down, people not being able to do business etc. And worldwide, a liquidity crisis of gargantuan proportions. This made the RBI (and yes, most other central banks) drop rates big time and pump liquidity into the markets. RBI provided banks with money in a special “Targeted Long Term Repo Operations” (TLTRO) for three years at very low rates (as low as  4.4%)

This added up to over 73,000 cr. in money that banks get at a very low rate. And they’re all maturing in the next two months, by the end of April.

TLTRO

What does the end of TLTRO mean?

Well, interest rates are up. Banks are parking this liquidity back with the RBI at 6.25% in the SDF discount window. Okay

Simply put, RBI gave banks around 75,000 cr. of money at 4.4% three years back, and is allowing them to park it back with it at 6.25%, effectively giving banks 1.85% of “free” money now. Effectively, that’s around 1,300 cr. of free money, which isn’t meaningful today, but it’s something.

The end of TLTRO means banks return the money to the RBI. When the money goes, their “free interest” also goes. For banks it’s not that much of a problem right now, but to get more money they will have to borrow from the market, where rates are climbing rapidly. And money is getting more and more scarce.

Money’s costly across the board

The Yield curve for the government (corporates are higher, marginally) is like this:

Yield Curve

It’s so flat that Bangalore roads are jealous.

Look at how steep it used to be. A year back, 6 month rates were 4.5% but now they’re also 7%+. Longer term rates started going up in 2021 itself. What’s happening right now is: Rates for any maturity is roughly the same.

And money’s getting more expensive for banks and corporates too. Short term money – in Commercial Paper and Money Markets – is now going closer to 8%. Even an HDFC Bank is paying 7.8% for about 300 day borrowing.

Banks are raising their deposit rates and soon, this will hit lending rates too. The pace of deposit rate hikes is increasing and for lending rates, even faster:

Lending and Deposit Rates

Some part of this will hit the market slowly. Home loan rates may rise but they will hit borrowers only on a reset date – which can be 1 year for older loans, and is about 3 months for loans made after 2018. Corporate rates are rising already.

So, Is there an opportunity?

There’s both risk and reward here.

First, on fixed income, here’s a thought process:

  • Rates are likely to go up across the board anyhow, if inflation remains high. The yield curve may actually invert, but it doesn’t mean that much for India (we have had inverted yield curves many times)
  • For any short term needs, anything above the 6 month duration now yields 7% or more. Meaning, you can invest in a good low duration or ultra-short term fund.
  • For longer term needs, the question really is – when should you move to the longer term bonds (10 year or more). There will be a time, but it doesn’t seem to be now. The most opportunities period will be when the RBI pauses rate hikes. It appears, with the commentary, that they’ll follow the Fed. And the Fed is likely to raise by at least 0.5% in this year. Expect the long bonds to move towards 8%.
  • Given that rates at even 7% are much higher than inflation, you can “lock in” some longer term rates if you don’t care about how yields move in the next few months. That means the next year could be lousy – but you have to stay put for three years.

You could buy many government bonds for 7%+ even for three months to maturity, through T-Bills (there are auctions every week accessible on the RBI Retail Direct platform)

Locking in yields for a tax-efficient 3 or 4 years

If you have the appetite to hold for three or four years years, one tax efficient strategy is using a targeted maturity fund. Such as the IDFC 2027 Gilt fund (see here) which has roughly 7.5% in yield in its portfolio and matures in 2027. If you buy in March 2023 and exit after April 2026, you get 4 years of indexation. With that, your effective tax rate will be very low and post-tax returns are close to 7.1%.

Even if by that time yields are as high as 9%, the post-tax return will be 6.4% for you (in 2026).

(Assuming inflation is at 5%, and an expense ratio of 0.2% on such a fund)

Of course, you should not want to exit in the interim. This process just locks in a yield for three years. Given we expect yields to go up, there may be more such opportunities in the future. Just placing it out there in case you don’t want to have to wait.

Risk: The impact on stock markets

Generally, interest rate hikes tend to hurt the stock market. But that’s because usually corporates are heavily leveraged. This time, however, regular industry is not that highly levered, considering that industrial credit growth, over the last five years has not been too high.

Annualized 5 year credit growth summary

Since industrial credit hasn’t grown quite that much, systemic defaults are unlikely in the industrial domain.

The problem is retail loans. Loans to individuals – from housing loans to credit cards to personal loans, have seen much stronger growth in the last five years. Both directly from banks, and by NBFCs (which tend to borrow from banks too). The scorching growth of the last few years combined with sharply rising rates means only one thing: bad loans will happen.

Now, given the environment, most of the larger lenders are well capitalized to deal with these issues, especially in the banking system. However, the NBFC system is going to have to take a few heavy punches. And that will probably mean a lot of startups as well, and a few of the smaller lenders in the lot. Just like corporate lending was a bad phrase a few years back, it’s likely that retail lending will become dangerous. Given the nature of the game, we have to avoid only the extremely levered businesses that lend to (or depend on the borrowing of) retail individual borrowers.

So, we have to be careful of smaller NBFCs, real estate and smaller companies that have trouble raising working capital debt. But by and large, this looks like a problem that will hurt the SME and small enterprise sector far more – thus empowering the bigger companies in India, most of which are listed. Meaning: the rich will get richer, and some of the poor will have to shut shop. From this will rise more companies and a stronger system – the basis of creative destruction – but it will mean more power for the larger listed companies. In effect, the bad news might actually be bullish.

This is just a quick macro update. We’ll have much more when there’s action that can be taken, and macro news that actually moves markets.

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