RBI's 'Operation Twist' promise drags down long-term yields sharply

The 10-year bond yield fell 15 basis points (bps) on Friday, while that in the 14-year segment fell 20 bps, which according to bond market dealers helps the government borrow cheap provided the central bank continues to do such market intervention.

The 10-year bond yield closed at 6.604 per cent after the Reserve Bank of India (RBI) said it will buy 10-year benchmark bond, and sell four short-term bonds worth Rs 10,000 crore, on Monday.

If the central bank made it a one-off exercise, then the yields should climb back, the bond dealers said.

The yields on one-year bonds rose 5 bps, as the central bank moved to correct the steep yield curve.

According to Badrish Kulhalli, head of fixed income at HDFC Life Insurance, the spread between the overnight and 10-year bond had climbed to 160 bps, but the long-term average has been 80-100 bps, which the central bank is probably trying to achieve.

The high spread gives banks ample opportunity to a safe arbitrage, in which they can borrow short and invest in longer dated bonds at a risk spread of nearly 2 percentage points, bond dealers say. If the longer-term yields come down, that arbitrage opportunity lessens significantly. The short-term rates, however, are determined by liquidity and repo rate. While the liquidity is abundant in the system, and repo rate is low, the short-term yields can’t remain high for long.

“After December, the short-term yields should come down. This is a short-term phenomenon, a near-term dislocation, which should rectify itself,” said Kulhalli, adding this is unlikely to be a policy tool for the central bank, but a “specific tool to address very steep yield curve”.

This is also not a countercyclical policy response, IDFC Mutual Fund wrote in a report. Term spreads, the difference between one-year yield and 10-year yield, are the highest since 2010, but this is happening now even as credit growth has collapsed and liquidity remained abundant.

“Just as commentators have observed that credit spreads need to be brought down for the riskier borrower, there clearly has been a need to bring down sovereign term spreads as well. While the effect to the overall system is decidedly lower than compressing the credit spread, it is still of relevance and can be executed with much less moral hazard,” IDFC AMC wrote in the report.

However, there are those in the market who don’t see much merit in softening the longer-term yield curve, except to make the government borrowing cheaper.

“When the US does Operation Twist, it affects lots of loan products linked to 10-year and 30-year bonds. In India, such products simply don’t exist. Banks’ lending rates are calculated based on short-term rates, by trying to push them up, the RBI is hardly helping in transmission,” said a senior economist, requesting anonymity.

“In any case, the RBI will have to be very repetitive in such operations, otherwise 10-year bond will again reprise itself,” said the economist.

However, by doing so, the RBI risks inverting the yield curve, in which longer tenure bond yields are lower than the smaller one. Such yield curve technically signals a recession.

As far as corporate bonds are concerned, such operation doesn’t help the lower rated companies much because they were not able to tap the bond market anyway. However, if the short-term rates rise, it may hit the same set of companies, and even better rated ones from tapping the commercial paper market for their working capital requirement, bond dealers said.