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THE yield curve shifted marginally week-on-week. The benchmark 10-year yield stood at 6.38 per cent, 5 bps lower than the previous week. Going forward, bonds are likely to trade in range, but could remain bid. Consider the factors: First, the next bond auction according to the RBI calendar is only in the first week of January.

With no fresh bond supply till then, dealers are likely to bid up bond prices in the secondary market, as the system continues to be flush with liquidity. Second, based on the forward yield curve, the long-term bonds appear rich, especially the 15-year and 30-year sectors. The 10-year sector appears somewhat cheap, but it is a moot point whether the dealers will bid up its price.

The reason is that short-term spread, which is the yield differential between 10-year and 2-year sectors, has remained constant for quite sometime now. And there appears no reason for this spread to tighten further.

Third, the RBI has conducted OMOs at regular intervals to drain excess liquidity in the system. This can be construed as a signal of the central bank's discomfort with the tight yields. Besides, OMOs have now become necessary to sterilise the liquidity brought to the market by RBI's dollar purchases.

The upshot is that the possibility of RBI holding OMOs is likely to keep bond dealers wary, and that could cap the upside. Fourth, with bond yields falling so sharply, investors are increasingly indulging in duration extension to benefit from the yield pick-up in long-term bonds. This has resulted in concave-shaped yield curve. Bidding up long bonds further would only lower their convexity-advantage, and further flatten the yield curve.

That is unlikely to happen, give the current spreads across maturity sectors. In all, bonds are likely to trade in range, but with an upside bias.

B. Venkatesh

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