Indian bond yields under check after Yellen move

The US Federal Reserve playing to the script and hiking rates by 25 basis points, kept Indian bond yields under check. The yield on 10-year G-Secs more or less remained at 6.8 per cent levels. The US Fed also stuck with its policy of gradually raising rates, penciling in two more quarter-point increases in 2017 and three more in 2018 — their projections remaining unchanged from that put out in December.

While this is likely to keep our bond yields under check, as the market has been more or less factoring in two more rate hikes by the Fed this year, gradual hardening cannot be ruled out. Near-zero possibility of further rate cuts by the RBI, volatility in foreign flows from the domestic debt market, measured buying of government bonds by domestic institutions and the RBI not conducting OMOs — buying of government bonds — at the same pace as last year, will continue to add upward pressure on domestic yields.

The relatively higher interest rates in India have always been a big draw for foreign investors. But the spread between the US and India 10-year benchmark bonds has been shrinking over the past couple of months. With US bond yields currently at 2.5 per cent levels, the spread is around 400 basis points, down from the historical average of around 550 basis points. Aggressive hike in US rates can see outflows from emerging bond markets piling pressure on our bond markets, too.

On a nominal basis, Indonesia is another country that offers high interest rates on its 10-year bonds at 7.2 per cent. Just as in India, inflation in Indonesia, too, inched up to 3.8 per cent in February. But real returns on Indian bonds are a tad less attractive. With the current CPI inflation at 3.65 per cent, real return on the 10-year G-Sec is about 3.2 per cent.

The real return in the US works out to 0.6 per cent. If the Fed increases its rates sharply, the rate differential between India and the US is unlikely to hold out, driving foreign investors away from our markets.

For now though, the Fed has quelled fears, sticking with its policy of gradual increase in rates.

Foreign investors’ appetite for government bonds has been waning, as seen in the data put out by NSDL. One way of gauging the inclination of foreign portfolio investors (FPIs) to invest in government securities is to look at the debt utilisation level. As of March 14, 2017, FPIs have utilised only 63.9 per cent of their limits to invest in government securities.

After pulling out close to $6.3 billion from the debt market in 2016, FPIs have poured in close to $697 million in 2017 so far.

On the domestic front, the aggressive buying of government securities by banks, particularly PSBs, lent support to bond prices last year. In the month of November, PSU banks were net buyers in government securities to the tune of about ₹25,900 crore. Private banks too bought (net) around ₹20,000 crore. In the month of December, the buying spree continued for PSU banks, which made net purchases of a whopping ₹61,000 crore, even as private banks turned net sellers.

However in January, both PSU and private banks were net sellers to the tune of ₹38,000 crore and ₹7,200 crore, respectively. After turning net buyers (marginally) in February, banks have once again started selling government bonds this month.

A mix of domestic and global factors are likely to weigh on bond markets from hereon. While there can be demand for G-Secs by banks because of lack of lending opportunities, limited upside in bond prices will curtail aggressive buying.

The yield on G-Secs has now moved 60 basis points above the repo rate (6.25 per cent) — at which banks borrow short-term funds from the RBI.

Bond investors should invest a chunk of their debt fund investments in short-term income funds that carry less volatility in returns.

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