Bond yields have seen something of an upward bias since August, spiking to nearly 6.6% in intra-day trades on a couple of occasions. That’s despite a 100-basis point (bps) cut in the repo rate since February, of which 50 bps came in June. To begin with, the weak run rates for corporation and income taxes in the first half of the year have got the bond markets worried. Both corporate tax collections and income tax collections are trailing the estimated growth rates. Indirect tax collections too are tracking well below the asking rate. To be sure, any shortfall in the tax mop-up will be made up through non-tax revenues and a possible cut in expenditure, so there is little risk of the fiscal deficit slipping. But despite the finance minister making it clear that the government will not borrow more than it has planned to, in the current fiscal benchmark yields remain elevated. They were somewhat softer through October trading around 6.48-6.57% after the government fine-tuned its borrowing calendar and reduced the share of bonds in the 10-20 year bucket.
Nonetheless, yields continue to rule at above 6.5%. In fact, foreign portfolio investors bought $1.6 billion worth of sovereign notes in October, more than the $1.2 billion bought in September. Demand from banks has been lukewarm. With deposits not growing as fast as they may have wished, banks have been paring some of their bond investments. In fact, they have actually been holding more securities than they are mandated to. While the statutory liquidity ratio (SLR) requires them to hold 18% of their net demand and time liabilities in government paper, the SLR for the system has been much higher at 26-27% in mid-October. It seems unlikely that deposit growth will pick up meaningful pace beyond the current rate of 9.9-10.1%. As such, banks might need to sell more from the stock of gilts should demand for credit go up sharply in the coming months. Also, the durable liquidity surplus in the system, which was over `5 lakh crore in mid-September, has fallen to `3.3 lakh crore by end-October.
It’s not just banks, demand from insurers too has been muted. Also, this year states have front-loaded their borrowings and since yields on these papers are higher there was some transmission to sovereign yields. There have also been some transient factors at play. For instance, in early August, mutual funds, who don’t own a very big share of the outstanding holdings but trade very actively, were sellers as some stop losses were triggered. For its part, the Reserve Bank of India (RBI) has signalled that it doesn’t want yields to rise by not accepting bids beyond a certain cut-off rate.
The problem with the yield on gilts remaining elevated is that the cost of borrowing in the corporate bond market stays higher. Corporate bond issuances have slowed somewhat as companies are either postponing their borrowings or are getting finer rates from banks. Should the spread between the 10-year yields of US treasuries and the local benchmark widen further, from around 240 bps currently, we could see further inflows from foreign funds supporting the demand for bonds. However, at this point it is hard to see yields falling sharply. In the meantime, with liquidity likely to tighten, the RBI may want to make some bond purchases.