Bond yields out of sync with rate outlook

Whispers about bank arrangements to drive up prices.

The bond market is witnessing an unprecedented phenomenon. Yields on government securities have been going down sharply despite three key negatives: the inflation rate has been shooting up, the Reserve Bank of India is dropping broad hints that interest rates may go up, and the US Federal Reserve is believed to be readying for another interest rate hike this month.

The yield on the benchmark 10-year paper dropped to 5.88 per cent on Friday, 19 basis points below the inflation rate. Moreover, the spread between the yields on the 10-year paper and the 5-year paper narrowed to 3 basis points, with the yield on the 5-year paper hovering close to 5.85 per cent.

This is not the only anomaly in the bond market. The spreads between two papers of the same maturity are widening to an amazing level.

Look at the yield on two 10-year paper. The yield on the 7.37 per cent 2014 benchmark paper on Friday was 5.88 per cent, while that on the 11.83 per cent 2014 paper was 6.91 per cent --- a gap of 103 basis points. Similarly, the 7.49 per cent 2017 paper was trading at 7 per cent, while the 8.07 per cent 2017 paper was trading at 6.3 per cent on Friday.

Said a banking analyst, who oversees the bonds business at a brokerage house: "Normally, the spread between 10-year and 5-year gilts is 30-40 basis points, which gets widened to even 50 basis points in a bearish market. Now, this has shrunk to an abnormally low level. Similarly, the difference between the yields on two papers of the same maturity is not more than 50 basis points. The bond market is an island of distortions and yields are not in sync with economic fundamentals and the interest rate outlook."

Another analyst said, "In this market, the entire price discovery mechanism has become distorted."

Observers are blaming the public sector banks and alleging that they have worked out an informal arrangement to drive down yields on government papers to protect their balance sheets.

"There is a concerted move by state-owned banks to drive down the yields on the most-traded papers. After doing that, they will target illiquid papers too. The objective is to drive down the yield to take advantage of the new RBI investment norms," said a private sector banker.

The chairman of a state-owned bank, however, said market forces were driving down the yields.

The RBI had on Thursday allowed banks to shift a larger portion of their investment portfolio to the held-to-maturity category, which does not need to be marked to market at the year-end.

However, banks will be hit, albeit in a small way, when they transfer their statutory liquidity ratio securities to the held-to-maturity category as the cost of shifting will be at the market price, which is lower than their acquisition price and the depreciation on such transfers should be fully provided for.

In the beginning of this fiscal year, the yield on the benchmark 10-year paper was 5.16 per cent. On June 30, at the end of the first quarter, it went up to 5.83 per cent. Now it is veering around 5.88 per cent. Market observers said it could be driven down to 5.60 per cent by the end of this month.