Yields on 10-year Government of India bonds have dropped to 7.97 per cent, below the Reserve Bank of India’s (RBI) benchmark “repo” rate of 8 per cent. Harish Damodaran explains the significance of this in the backdrop of recent developments in the domestic bond market.
Why are bonds so hot now? Foreign institutional investors, for instance, have poured in $25.3 billion into India’s debt markets so far this year, as against just $ 16.5 billion of net equity purchases…
Bonds are essentially fixed-income securities offering investors an interest rate (coupon) along the original principal on maturity. Returns on Indian bonds are amongst the highest in the world today. The last auction of 10-year government security on November 28 fetched a yield of 8.1 per cent, which, on a consumer price inflation of 6 per cent, translates into a real return of over 2 per cent. For global investors, an 8 per cent return is great, especially when the rupee isn’t particularly vulnerable to depreciation (unlike last year) and 10-year bond yields are ruling at 0.4 per cent in Japan, 0.75 per cent in Germany and 2.3 per cent in the US. It makes good business to borrow overseas in dollars or yen and invest in rupee-denominated Indian bonds. The best time for this is now — before RBI starts cutting policy interest rates.
Given that, why is the 10-year bond yield dropping below the repo rate such a big deal?
The repo rate is what RBI charges for overnight, i.e. one-day maturity, lending to banks. Normally, short-term interest rates are below long-term rates. This results in an upward sloping “yield curve”, reflecting higher yields for longer-term investments. What we are now seeing is the reverse, with the cost of 10-year money being higher than that of one-day money. An “inverted” yield curve, in other words.
What does this signal?
An inverted yield curve is usually associated with an impending recession. When short-term interest rates exceed long-term rates, it points to lack of lending opportunities for projects that take into account prospects for the economy beyond the immediate future. If that outlook is poor, nobody would want to borrow for the long-term and the demand for funds is limited to the short end of the market.
This may, however, be an exaggerated view in the present circumstances. The inverted yield curve in this case seems artificial, having more to do with a deliberate RBI move to keep policy rates high.
That surely needs explaining.
Since September 30, when RBI presented its last monetary policy review, yields on 10-year government bonds have fallen from 8.51 to 7.97 per cent and touching 7.94 per cent in intra-day trade on Wednesday, the lowest levels since July 19, 2013. This has happened despite RBI keeping its repo rate unchanged at 8 per cent. The repo rate was 8 per cent even when 10-year yields hit a high of 9.1 per cent this year on April 7. If market bond yields are falling with an unchanged repo rate, it suggests a deliberate central bank policy to push short-term rates higher, generating an artificial inverted yield curve.
But why are bond yields falling and why is RBI apparently not factoring this while keeping its policy rates unchanged?
Yields declines take place when there is expectation of interest rates falling. It results in high demand for bonds that were issued at high coupons. As high demand pushes up bond prices, their yields drop correspondingly – to even below the original coupon rates. For illustration, consider a bond with 10 per cent coupon bought at an issue price of Rs 1,000. The annual yield-to-maturity in this case is 10 per cent (100/1000). But if the bond price shoots up to Rs 1,200, the yield falls to 8.33 per cent (100/1200).
The bond yield declines now taking place are simply on account of the markets factoring in interest rate cuts — which they see as inevitable in a context of global crude prices crashing and reinforcing bearish pressures on other commodities as well. The RBI, however, wants more conclusive evidence of the “ongoing disinflationary impulses” being real and durable.
Is this the first time we are seeing an inverted yield curve?
No, this happened last year, too, when RBI raised lending rates under its marginal standing facility as part of exceptional liquidity tightening measures aimed at defending the rupee. The idea behind hiking the cost of short-term borrowings, then, was to deter speculators who were allegedly using these to accumulate dollars and “short” the rupee. But today, there is no such threat. And with inflation clearly on a downward trajectory, there is simply no reason for RBI to keep policy rates high for too long. At least, that’s what the markets believe.