The Hindu Business Line : Bonds likely in tight range

THE yield curve ended marginally higher week-on-week. The 10-year yield was up 4 bps compared with the previous week. Going forward, bonds may continue to trade in a tight range with a somewhat upside bias.

The primary factor driving sentiment last week was the expected cash outflow from the banking system due to advance tax payments, and the higher inflation in the manufacturing sector. The first 2 days of the coming week may see some downside in bond prices on account of this factor.

But cash outflow from tax payments appear to be a sentiment-driven factor and may not be a cause for concern, as liquidity still appears comfortable. For one, banks and primary dealers lent over Rs 9,000 crore to the RBI through the 3-day repos. For another, the bids at the recently conducted OMO for the 2019 bond were substantially higher than the notified amount. Liquidity-driven price appreciation maybe capped near the current levels.

The market seems wary of further collapsing the term structure. This is evident from the market maintaining the long-term spread around 85 bps and the short-term spread at 55 bps in the last couple of weeks. This suggests that the short-end yields should also come down if the dealers bid up long-term prices. And that may not happen, as the spreads over the repo rate are already tight.

Besides, the highly concave shape of the yield curve lowers the convexity advantage from investing in long-term bonds. Then, there is the high yield volatility. These factors make it very risky for even the aggressive traders to engage in carry trade.

Therefore, the liquidity factor may keep bonds bid but the already tight term structure will cap the upside. Funds with exposure to long-term bonds may see better returns than ones invested in medium-term sectors.

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