Bonds sold off sharply on Tuesday, spooked by Reserve Bank of India (RBI) deputy governor Viral Acharya’s comments the interest rate risk of banks could not be managed over and over again by the regulator. Acharya had observed late on Monday that large holdings of G-Secs and state development loans by banks exposes them to “re-pricing of governments’ borrowing costs which could rise due to inflationary, fiscal or other domestic as well as global macroeconomic developments”. The DG was speaking at an annual dinner hosted by the Fixed Income Money Market and Derivatives Association of India. Acharya asserted that the trend of regular use of ex-post regulatory dispensation to ease the interest rate risk of banks was not desirable from the point of view of efficient price discovery in the G-Sec market and effective market discipline on the G-Sec issuer. “It also does not augur well for developing a sound risk management culture at banks,” he said.
The yield on the more widely-traded benchmark surged to 7.58% intra-day before ending the session at 7.55%, the highest level since it was introduced in May last year. Should the yields stay at these levels, not only will the government’s borrowing costs go up, banks too could refrain from lowering interest rates on loans. Already, the central bank has in the past one month twice deferred a part of the bond auctions. In late December, it did not accept any bids for two sets of gilts worth Rs 11,000 crore; only Rs 4,000 crore of supply hit the market. In the first week of January, the RBI did not accept bids for two long-dated papers worth Rs 4,000 crore. Banks, whose bond portfolios have already been hit with the yield moving by 90 basis points between October and December, could be staring at bigger losses.
The yield has now risen a good 110 basis points over the last six months. The newer 10-year benchmark yield closed at 7.38% on Tuesday, 11 basis points higher than Monday’s close and the highest level since the paper debuted in January. Most dealers believe the spike in yields is a knee-jerk reaction and hope rates will settle somewhere around these levels. Ananth Narayan, professor, finance, at SPJIMR said the base case remains that the RBI will remain on a long rate pause. “A higher twin deficit and prospects of higher inflation can change outcomes,” Narayan said. Jayesh Mehta, country treasurer, Bank of America, noted that there was a demand and supply mismatch with supply clearly overshooting demand currently. “There is more supply than the market can absorb. And it will become difficult for those sitting on losses to add to their portfolios,” Mehta said. Bond yields have been rising continuously over the last few months led by various concerns including inflation, fiscal deficit, oil prices and US treasury yields. CPI inflation for December, at near 5%, was in line with expectations and oil prices continue to be a cause for concern. On Tuesday, Brent crude prices were hovering near the $69.41-a-barrel mark while the 10-year US treasury yield was trending near the 2.52% level.
Vijay Sharma, senior EVP, PNB Gilts, indicated that trying to predict a range or target for yields was becoming a futile exercise. “Even a small piece of negative news is amplifying the impact on prices because because of the complete lack of any demand from investors,” Sharma said. Narayan pointed out that while on the one hand the RBI manages financial stability and monetary policy, on the other hand, it is also a merchant banker to the government’s borrowing programme. “Likewise, banks and primary dealers are forced to take up residual bond supply that isn’t absorbed by other real investors, while still being having to manage its overall market risk,” he said. “Recourse to such asymmetric options — heads I win, tails the regulator dispenses — is akin to the use of steroids. They get addictive and have long-term adverse effects in the form of frequent relapses even though their use may be justified to relieve occasional intense pain,” Acharya had noted. Narayan said if floating rate bonds were issued, for the first year the government’s cost would just be the one year T-bill rate. “Of course they have the risk that the yields can go up. But that’s the one thing that the RBI or the government can do right away,” he said.