Bond yields hit record lows, likely to rally more

Mumbai, Nov 27: Yields on Indian government bonds dropped to historic lows on Tuesday, swept under a huge liquidity overhang, and traders see little reason for the rally to end with the central bank silent and demand expected to stay strong. The benchmark 10-year federal bond yield sank to 8.02 per cent, erasing last week’s previous record low of 8.1 per cent.

The yield is down 110 basis points since October 22 when the central bank announced a cut in the bank rate and cash reserve ratio, fuelling the fall.

Compared to a year ago, the yield down a whopping 334 basis points, and the Reserve Bank of India (RBI) has done nothing to check the runaway drop in yields.

“The RBI’s inaction seems to suggest that it is comfortable with the falling yields,” a primary dealer said. “They are not doing anything to instil a sense of apprehension.”

With sluggish economic growth stunting demand for loans, low inflation and softer interest rates have supported the liquidity driven rally in government bonds, traders say.

Latest RBI data show deposits with commercial banks rose Rs 899.86 billion, or 9.3 per cent, to Rs 10.53 between April 1 and November 2, while demand for loans was Rs 5.46 trillion, up 6.7 per cent. Much of the surplus cash is being pumped into bonds, with banks’ investments up 12.5 per cent at Rs 4.16 trillion so far this financial year.

And the RBI estimates that deposits should grow by another Rs 440.14 billion by the end of the financial year in March.

There will also be routine inflows from bond coupon payments and redemptions. Further, if financial institutions go ahead with plans to become banks by March, they will have to invest in government bonds to meet the RBI’s liquidity ratio requirement.

Fresh bond supplies from the government may not be enough to satiate the potential demand.

The Centre has around Rs 111 billion of bonds left to issue, having completed nearly 91 per cent of the Rs 1.19 trillion budgeted programme for the current year.

Analysts do not expect the government to overshoot the target by more than Rs 35 billion. This will result in a lot of money chasing a limited supply of bonds and fuel the rally. Falling yields are squeezing the earnings of banks.

On an average, their cost of funds is around 7.0-7.5 per cent. With the 10-year bond offering a pre-tax return of 8.02 per cent, some could even face a negative spread.

“It is difficult for banks to bring down deposit rates,” said Suresh Prabhu, chief dealer at HDFC Bank. “Banks are competing with higher yielding savings instrument from the government.”

Government-run small savings schemes offer post-tax returns of 13.7 per cent. In contrast, long term bank deposits offer a maximum of 11 per cent.

“But if the central bank is taking a stand on softer yields, banks will have to decide whether they want to raise deposits at those higher rates,” a primary dealer said. Indian rates are higher than in advanced countries. Leading banks’ lending rates, for instance, are around 11.25-11.5 per cent compared with 5 per cent in the United States.

— Reuters