The economy is heading for a slowdown and bond yields are not far from peaks seen during the year. This by itself is a good case for buying into bond yields and the risk return profile of investing in bonds is very much in your favour. Bond funds that invest in government and corporate bonds are an alternative if you do not want to invest directly in bonds.
Ten year benchmark government bond yields are trading at around 8.25% levels. The peak seen on the 7.80% 2021 government bond, which is the benchmark ten year bond, is 8.45%, seen in May 2011. Benchmark AAA corporate bonds of five and ten year maturities are trading at close to 9.5% levels, down from peaks of 9.75%. The current levels of bond yields are at close to three year highs and the levels are where they are due to inflation. Inflation as measured by the WPI (Wholesale Price Index) is running at 9.06% levels and is expected to come in higher for the month of June, due to the fuel price hikes by the government in June. The RBI has raised the benchmark policy rate, the repo rate by 275 bps over the last fifteen months as inflation kept steadily moving higher from levels of 5% to levels of 9% and above. The repo rate is at 7.50% at present.
The economy in the meanwhile has show signs of slowdown. The IIP (Index of Industrial Production) growth for the month of May 2011 came in at 5.6%, against market expectations of over 8%. The IIP growth for May 2010 was at 8.5%. IIP growth for the month of April 2011 was at 5.7% taking the April-May 2011 average to 5.7%. While two months of weak industrial growth does not indicate a slowdown for the full year, the environment outside does suggest that the economy can slowdown faster than expected and force GDP growth numbers for 2011-12 to be revised downward from 8%.
The fall in IIP growth for May is to be seen in conjunction with the status of growth drivers in the economy. Monetary policy is tight and its effects are seen on credit growth, which has fallen from levels of 23.5% to levels of 20% over the last six months. Interest rate sensitive industries from auto to real estate are seeing a slowdown. Vehicle sales growth has dropped from high double digit growth levels to low single digit growth levels. Infrastructure spending is coming off due to tight liquidity and high interest rate conditions (as per industry leaders). Financial services sector is facing issues of a weak capital market with broad equity indices still trading below levels seen in late 2007. High interest rates and weak capital markets are forcing corporates to put off expansion plans. There is clearly a case for the economy to slow down further.
The economic environment in the global front is not looking positive. Economic growth in the big economies of US, China and Japan is looking to come off. US unemployment rate at 9.2% has gone up from below 6% levels seen in 2006 and is not looking to go down soon. China is fighting inflation, which is trending at 6.4% levels and has raised rates and lowered growth forecasts. Japan is coming out of a natural disaster that closed down it nuclear facilities. Eurozone is facing a debt crisis and many countries in the Eurozone including Greece, Spain, Portugal, Italy and Ireland will see growth come off sharply on spending cuts, and this will bring down growth in the region.
Growth drivers absent, inflation drivers such as demand and commodity prices will also cool off leading to falling inflation expectations. In such a scenario, bond will do extremely well and at levels close to three year highs, chances of yields falling is much better than chances of yields rising.
The author is editor www.investorsareidiots.com a financial web site for investors.
