Amid tight liquidity conditions in the banking system, banks have cut down on their investments in short-term government bonds, according to dealers. At the same time, banks are shifting towards building up positions in the longer duration papers due to rising bets on the Reserve Bank of India (RBI) cutting rates in February.
Market participants expect rates of T-bills and short-term bonds to remain sticky unless liquidity conditions ease.
A large section of the market is anticipating a cut in the policy rate by the central bank in February. Generally, when the rate cut happens, long-term bonds tend to perform better than shorter duration papers because investors lock in a higher interest rate for a long period of time.
For the ultra long-duration papers with a maturity of and above 30 years have seen firm demand from insurance companies, pension funds, provident funds, and even some mutual funds as well. Mutual funds, usually, don’t prefer to lock in money in ultra long duration papers.
However, with the increasing chances of the domestic rate cut, fund houses have also taken long positions in ultra long bonds, said the dealers.
“Duration papers are preferred because overnight rates are hovering around 6.90% levels, consequently T-bill rates are high. Initially, there was a thought that short-term yields would fall faster than long-term but due to funding crunch, making money on short-terms papers is difficult,” said a trader at a private bank.
Despite the cut in the cash reserve ratio (CRR), the liquidity deficit in the banking system crossed Rs 2 lakh crore. Intervention in the foreign exchange market is a key reason for tight liquidity as the central bank is said to selling dollars to stem the depreciation of the rupee.
Looking ahead, the structural liquidity is expected to remain under pressure as the rupee will continue to face the heat of an elevated dollar. This may prompt RBI to intervene in the spot market, further wiping out the liquidity in the system.
Meanwhile, long-term bonds are not vulnerable to the liquidity conditions of the banking system, rather they are more susceptible to any change in the rate cut cycle. New RBI governor Sanjay Malhotra is considered positive for the market and perceived to be dovish in his approach, thereby boosting investors expectations of a domestic rate cut.
“Banks’ investment strategy for long-term bonds is impacted by rate cut expectations. As long as the expectations are intact, duration will going to perform well. When the liquidity is tight and rate cut bets are still on, I will continue with duration papers,” said VRC Reddy, deputy GM-treasury, at Karur Vysya Bank.
Market participants are expecting the RBI to introduce additional measures to infuse liquidity in the banking system such as open market operations or buybacks.
