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THE yield curve shifted marginally down week-on-week. The 10-year yield closed below 6 per cent. The primary reason for the bonds closing firm last week was the statement from the RBI Governor, Dr Bimal Jalan, that the RBI was not targeting specific yield levels.

Going forward, bonds are likely to remain bid in the coming week. The 10-year yield is expected to decline 10-12 bps. This may prompt dealers to bid other maturity sectors as well. Besides, the RBI has not scheduled any auctions in the near term. This lack of fresh supply may prompt dealers to keep bonds bid.

The upside in long-term bonds, however, seems limited. The reason is that the yield curve risk, especially at the long-end, appears very high, even adjusting for the convexity gains. It is a moot point whether yield investors will continue to stack their portfolio with long bonds at the current prices.

Then, the spread between the overnight rate and the yield at the long-end is just 84 bps. This, indeed, provides limited room for sharp upside in bond prices, unless overnight rate falls. And that is unlikely to happen unless there is a repo cut.

Another factor is the shrinking term-spreads and `local' richness. If the long-term spreads are to remain at the current levels, the yield curve has to see a parallel shift downwards. But that appears unlikely given the `local' richness among several maturity sectors. The 2005 security, for instance, appears `locally' rich based on the forward yield curve.

This prevents dealers from sharply bidding prices, unless they provide for a change in the curvature of the yield curve.

Finally, the RBI has used OMOs in the past to prevent tightening of yields. This factor may place a cap on the upside in bond prices. In all, bonds are likely to remain bid, but carry limited upside.

B. Venkatesh

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