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Banks are planning to slow purchases of government securities until the end of September, executives and analysts say, after a sharp rise in yields that will pressure bottom lines already weighed down by bad loans.
The retreat by buyers in the face of an increased supply of govermment bonds could raise the government's borrowing costs.
That would be a blow to a government that has to spend more to boost economic growth, as it would have hoped to benefit more from the central bank's interest rate cuts earlier this year.
The government plans to borrow Rs 6 lakh crore ($94.5 billion) in the fiscal year through March 2016. So far, it has raised Rs 2.1 lakh crore.
"We will avoid adding big amounts to the trading portfolio," said state-run Union Bank of India Chairman and Managing Director Arun Tiwari in Mumbai.
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State-run lenders, which make up the bulk of India's banking sector, are the largest buyers of government bonds in the primary market, and profits from treasury holdings typically make up between 20 and 30% of their earnings.
But rising yields during the June quarter squeezed profits at a time when these banks are under pressure to improve profitability and margins.
"We are reducing duration on our trading books and will only buy to the extent of our requirement, not more than that," said a treasurer at another state-run bank, declining to be named as he was not authorised to speak to the media.
The central bank's surprise open market sale of government bonds this week added to pressure on yields. And traders expected more of these sales.
To meet India's statutory liquidity ratio (SLR), banks have to maintain at least 21.5% of their deposits in government securities, ensuring captive demand.
However, banks currently hold closer to 28% in government securities, seeking safe havens to counter loan growth hovering at the lowest levels since September 2014 and steady deposit growth.
But there was now an incentive to trim bold holdings.
Union Bank's Tiwari told Reuters that the cost of bringing in term deposits is higher than interest earned from buying a 10-year bond.
Though bond yields are up just 13 bps since the RBI began cutting interest rates in January, sharp swings in the second quarter, when the most traded 10-year bond yield rose 30 bps really ate into banks' earnings.
With worries that weak monsoon rains will push food prices high, concerns over inflation have dampened expectations for another rate cut in the near term, and dealers expect bond yields to rise another 15 basis points in this quarter.
If the RBI relaxes foreign investment limits in government securities it could bring some relief to the bond market, otherwise it is hard to see who would offset the reduced demand from domestic banks.
"There is no marginal buyer. Risk appetite has clearly shrunk," said a senior trader at a private bank.
"Unless foreign limits are relaxed or inflation falls below RBI's trajectory, the government will end up paying higher yields."
($1 = 63.5000 rupees)
