The Hindu Business Line : Worst over for Indian bonds

After hovering in a narrow range of around 5.25 per cent, 10-year yields shot up to nearly 6 per cent in June, following remarks of the RBI Governor that interest rates may have to rise.

Worsening inflation and shrinking liquidity took their toll and yields jumped further to 6.75 per cent before a sudden and unexpected rally to below 6 per cent. As the Wholesale Price Index (WPI) continued to mount week after week and the RBI raised the repo rate 25 basis points, 10 years finally crossed 7 per cent, with the recent peak being 7.35 per cent.

What's in store? Inflation - the main driver of bond prices - pushed past 8 per cent, but has since fallen back to 7 per cent levels. Though there is considerable volatility from week to week - it has even been suggested that the data could be released monthly to avoid knee-jerk market reactions - the downtrend seems to have begun.

The prognosis is positive. Agricultural harvests are starting to roll in and we should see a significant easing of the prices of primary articles.

Energy prices could stay high till the first quarter of 2005 to cope with the winter demand for heating fuel, but, given OPEC's current production levels and its commitment to reduce prices, they should ease significantly in the course of next year.

The country is awash with capital inflows and unlike 2003 and the early part of this year, the RBI may not be aggressive in stalling rupee appreciation, given the beneficial effect of a stronger currency on inflation at a time when the latter needs to be brought down.

Price pressures could arise in metals and manufactured products but these should be offset by falls in the other components of the WPI.

The Government's liquidity seems to be comfortable with improving tax collections. There is no Damocles sword of an overhang of new issues. Credit offtake is good, but, with the bigger corporates likely to venture into the booming domestic and offshore capital markets for Indian equity, it is unlikely that interest rates will have to rise much as a result.

Indian-US bond yield differentials, which touched a low of 75 basis points in late 2003, are now in the region of 3 per cent. They should move lower to around 2 per cent, partly on the back of rising US yields.

After a spurt to over 6 per cent - possibly because of the liquidity sucked out by MSS (market stabilisation scheme) bonds - overnight rates are back to repo rate levels.

The worst days are clearly over. There is value in the market given the attractive spread of about 2.5 per cent between 10 years and call.

Banks - the biggest holders of bonds - should breathe more easily in the coming months.

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