While the RBI came out with slew of measures recently to ease the rising yield on the 10-year G-Sec, its moves have triggered other worrisome trends in the bond market that can impede transmission. Aside from announcing two additional tranches of ‘Operation Twist’ (OT), the RBI had eased the held-to-maturity (HTM) limits for bond holdings by banks and also allowed banks to retire higher cost borrowings under previous long-term repo operations.

While these moves had the immediate desired impact of cooling off the yield on 10-year G-Sec by about 20 bps, they have in turn led to an increase in yield of shorter tenure, three- and five-year government bonds by 20-25 bps over the past week. As such, yields on these shorter tenure government bonds have been rising since July — by about 65 bps in the case of three-year and by about 35 bps in five-year government bonds. Given that the movements in three- and five-year government bond yield get transmitted to other bonds, and finally to loan rates, the uncanny rise in short tenure bond yields deters effective transmission of policy rates.

Weak execution

The RBI has been undertaking OT — essentially using proceeds from the sale of short-term securities to buy long-term government debt papers — in a bid to absorb the supply of longer tenure bonds to cap the rise in yield. But the weak execution of this move has created issues. The RBI, for instance, has been buying mostly older bonds under OT. In the recent September 7 auction, aside from this year’s 5.79 per cent 10-year G-Sec, the RBI also sought to buy 6.18 per cent 2024 and 6.97 per cent 2026 bonds, which are older bonds. The August 25 auction comprised purchases of 8.24 per cent 2027 and 7.95 per cent 2032 older bonds, among others.

“The measures announced recently, including the open-ended commitment to do more if needed, were confidence-boosting for the market,” explains Suyash Choudhary, Head, Fixed Income, IDFC AMC. “However, their execution thus far has left something to be desired. The incessant pursuit of the old 10-year bond in twist operations, while ignoring offers made in shorter term bonds, is somewhat peculiar. Furthermore, the window for banks to retire higher cost borrowings undertaken under previous long-term repo operations may well have unintended consequences as some banks may want to sell off the short tenor bonds that they were holding against these borrowings.”

While putting a check on the hardening 10-year G-Sec yield is also imperative for a conducive transmission, it is the shorter tenure bond yields that have a greater impact on loan and deposit rates.

“All in all, it is really shorter end rates that should be of more concern to RBI and it is here that its anchor should be more visible,” adds Choudhary. “Longer term rates can reflect larger term premia which is logical given the heavy fiscal load that the market has to finance. Therefore, for longer term bonds, the RBI can afford to be more light-touch in approach, ensuring only that the market functions smoothly. Whereas what is happening so far is exactly the reverse of this desired scenario.”

Measures announced

The yield on 10-year G-Sec had hardened towards the end of 2019, owing to worries over the fiscal deficit. Hence, as against a policy repo rate reduction of 135 bps between February and December 2019, the yield on 10-year G-Sec had fallen only by about 88 bps.

In a bid to ease the interest rates on long-term government bonds, the RBI began announcing OT in December 2019. These measures, along with the RBI’s monetary easing and continued liquidity infusion through Long Term Repo Operations (LTROs), helped the yield on government bonds (in particular, one- to three-year tenure) cool off. Between January and April 2020, the yield on 10-year G-Sec fell about 40 bps.

Yield on three- and five-year government bonds fell a sharper 150 bps and 90 bps, respectively, during this period.

But from the lows of July, yield on three- and five-year government bonds have risen sharply, owing to sell-offs in this segment. The RBI’s OT, mainly focussing on the 10-year bonds, has failed to check the rise in shorter tenure bond yields.

Fiscal worries

The yields on 10-year G Sec have remained sticky, owing to the Centre’s additional borrowing announcement in May (₹12-lakh crore in FY21 from the earlier estimated ₹7.8-lakh crore).

Alongside the fear of excess supply of government bonds, weak demand has also played truant. Foreign portfolio investors (FPIs) have been pulling out huge sums of money from the Indian debt market this year — ₹1.11-lakh crore of net outflow so far. In fact, FPIs’ appetite for Indian bonds had been tepid in 2019 as well.

The demand for government bonds by domestic banks also remained weak on account of fear of rise in yields and treasury losses, as banks have to mark-to-market such investments (not held in HTM). According to Bloomberg data captured from CCIL, PSU banks have been net sellers to the tune of ₹20,000 crore in government bonds between April and August.

In a bid to ease the risk aversion, the RBI eased the HTM holding norms for banks on incremental purchases from September onwards. Essentially, bonds held under HTM need not be marked to market. By hiking the HTM limit for banks by 2.5 per cent (of deposits) for the second half of this fiscal, the RBI has created an additional ₹3.6-lakh crore of buying window for banks, without having to worry about the fluctuation in bond prices.