The yield on the 10-year government bond inched up marginally after the RBI’s policy review on Tuesday. The central bank holding on to its policy easing stance and stating that it will review the limits for foreign investors in government bonds, failed to cheer the bond market.

The central bank has proposed a medium-term framework to link foreign portfolio investor (FPI) limits to outstanding government bonds. While this is expected to increase the current limits, market players expecting some concrete revision of limits were disappointed. The RBI has also pushed the review of limits to a later date, and said that it is awaiting more clarity on the Federal Reserve’s rate hike.

Currently, foreign investors can invest up to $30 billion in government securities. These limits have been fully utilised. According to the RBI, the limits will be reviewed every six months, and will be denominated in rupees, so they do not vary with changes in exchange rates.

According to market players, limits in rupee terms would further increase the scope for foreign investment as the current dollar limit is assumed at a rate of 49.8 to a dollar. The one-time conversion (at the current rate of 63) will automatically increase the foreign investment limit.

“There has been some expectation in the market about an imminent effective hike in limit and re-designation of quota in INR terms at the current exchange rate. This would have effectively hiked the FPI quota in government bonds by about ₹35,000 crore,” says Suyash Choudhary, Head-Fixed Income, IDFC Mutual Fund.

 While this will open more opportunities for foreign investors, the impact on the government securities market as a whole will be minimal. According to the quarterly public debt management report put out by the Finance Ministry for January-March 2015, FIIs constitute about 3.6 per cent of the outstanding government securities. Hence, even a 25-30 per cent increase in limits will increase its share of holding by only a percentage point.

Yields to remain high The yield on the 10-year government bond has been firming up since March, when the RBI made its second rate cut. The yield (7.8 per cent) is now about 50 basis points above the repo rate (7.25 per cent), the rate at which banks borrow short-term funds from the RBI.

The yields have been trending higher due to the recent turbulence in global bond markets. Also, the market has been tempering its expectations of further rate cuts.

But demand-supply dynamics have also limited the fall in yields.

The chunk (about 43 per cent) of government securities is held by banks. Banks already carry excess investments — 3-5 per cent more than the mandated requirement. Banks have also hit their ceiling in the held-to-maturity (HTM) category. Banks are allowed to keep a portion of their SLR securities under HTM, which helps in avoiding a mark-to-market (MTM) on those investments, thus lowering the volatility in their treasury income. Hence, banks’ lower appetite to invest in government securities has impacted yields to some extent.

The RBI’s recent slew of sale of government securities with a view to mop up excess liquidity has also put pressure on the yields.

Going by the banks’ borrowing through the liquidity adjustment facility (LAF), in July, average net absorption (surplus) amounted to about ₹18,000 crore. The RBI sold bonds worth ₹8,300 crore in the second week of July alone.

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