Panic in bond market due to short squeeze

10-year bond yield closed at 6.77% even as many illiquid bonds exchanged hands in the past two days

Bond market yields dived on Thursday and Friday as traders scrambled to cover their short positions.

According to traders, investors pushed up yields sharply after the central bank kept policy rates unchanged on February 8. Yields moved up from 6.4 per cent to 6.95 per cent in less than a month. Much of the movement had happened because primary dealers and foreign banks had shorted their positions, expecting yields to rise further. As yields rise, prices of bonds fall.  The expectation was that, by Thursday and Friday, they would be buying up the bonds from the market to cover the position. Public sector banks, sensing huge shorting, refused to sell bonds in the secondary market. 

What accentuated the shortage of bond supply was that the government has exhausted its borrowing limit and will no longer supply fresh papers in the market. 

Panicked bond traders therefore started offering hefty price for the same bonds to the public sector banks, pulling down bond yields by 20 basis points in two-three days. The 10-year bond yield closed at 6.77 per cent on Friday even as many illiquid bonds exchanged hands in the past two days.