Any further upward movement in Government Security (G-Sec) yields, even by 10 basis points (bps) from the current levels, could usher in mark-to-market (MTM) losses for banks, cautioned State Bank of India’s economic research report ‘Ecowrap’.

SBI’s economic research team believes one of the reasons for the recent surge in yields might be short-selling by market players.

The report said the Reserve Bank of India will have to resort to unconventional tools, including speaking to market players/off-market interventions, open-market operation (OMO) in illiquid securities and penalising short-sellers, to control the surge in bond market yields.

“The average increase in G-Sec yields across three, five and 10 years is around 31 bps since the Budget.

“AAA Corporate bond and SDL (State development loan) spreads have jumped by 25-41 bps during this period,” said Soumya Kanti Ghosh, Group Chief Economic Advisor, SBI.

While this significant increase in bond spreads is a manifestation of the nervousness of market players, Ghosh believes the central bank will have to resort to unconventional tools to control the surge in bond market yields.

Since January-end 2020, the yield on the most traded 10-year G-Sec (the 5.77 per cent GS 2030) has gone up by about 28 bps, with its price declining by about ₹1.90. MTM losses require banks to make provision towards investment depreciation.

Ghosh opined this is important as any further upward movement in G-Sec yields, even by 10 bps from the current levels, could usher in MTM losses for banks that could be a minor blip in an otherwise exceptional year in FY21 for bond markets, with the RBI assiduously supporting debt management of the government at lowest possible cost in 16 years.

In fact, the RBI strategy of devolving on the primary dealers (PDs) may have its limitations as standalone PDs account for 15-16 per cent of secondary market share and this may not be enough to move the market, Ghosh said. This share has remained broadly consistent over long periods despite excessive market volatility.

Short-selling

While going short or long are typical market activities that aid in price discovery, in times, it can result in price distortions, too, as it might be happening now, the report said.

Ecowrap noted that the banks and the primary dealers resort to short-selling when their view is bearish — that is, the prices of the bond will fall and the yield will rise.

“They make money if the bond prices drop and yields rise, and over a point of time, this could become a self-fulfilling prophecy as such short-sellers keep on rolling over their borrowed security from the repo market till the time they believe that yields will continue to rise,” it said.

Ghosh felt that the only way to break such self-fulfilling expectations is for the RBI to conduct large-scale OMOs to provide necessary steam to the bond market to rally and with increase in price, many short sold position will trigger stop losses and market players will scramble to cover open positions. This will hasten a rapid fall in yields over a short period of time.

RBI steps

The report suggested that the RBI could announce steps including announcing a weekly outright OMO calendar of ₹10,000 crore till March-end, reducing the time period for covering short sale from 90 days to 30 days, and prescribing a margin requirement for borrowing securities in the repo market while covering the short-sale position to cool the yields.

It also recommended allowing more players such as mutual funds and insurance companies in the repo market and penalising short-sellers.

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