G-sec yields to fall

A Bank of America Merrill Lynch report released last week expects 10-year G-sec yields to ease to 8-8.25 per cent by March. To investors in instruments such as infrastructure/tax-free bonds or post-office schemes, this could mean less attractive returns. Investors in gilt mutual funds, though, may benefit from a rally in bond prices. Here are the reasons why G-sec yields may fall, according to the report:

There were several risks to Finance Minister Arun Jaitley’s 4.1 per cent fiscal deficit target. These include ambitious tax projections, dependence of disinvestment targets on Fed tapering and risk of expenditure overrun due to deferrals from last year. These, the report says, will now partly be countered by proceeds from coal mine fines/auctions of more than $5 billion. The Centre also has a surplus of ₹1,284 billion with the RBI as of March 31, 2014, that can be drawn down, if needed. The drop in oil prices is another positive.

The report expects the RBI to cut interest rates by 75 basis points in 2015, beginning February, with inflation set to peak at 8 per cent in January 2015 and 6 per cent in January 2016. Late rains will likely facilitate winter sowing to douse inflation. Finally, the Fed rate hike expectations should hold oil prices in check. They expect the yield curve to flatten as the market prices in the possibility of RBI rate cuts.

Cuts in SLR (now 22 per cent), would be compensated by G-sec demand from banks to meet LCR (Liquidity Coverage Ratio) requirements, according to them.

Supply concerns are proving to be overdone. Borrowing for the second half of 2014-15 has been cut by ₹80 billion. What's more, open market operations/Government buyback of securities maturing beyond FY15 to the extent of ₹55,800 crore would clear the G-Sec market.

The US Treasury moves are expected to have limited impact on Indian G-sec yields. It is for this reason they do not think that any increase in US Treasury yields (3.1 per cent for 10-year yields by December 2014), driven by Fed rate hikes, will prevent G-sec yields from falling. They believe the RBI can cut rates even if the Fed hikes rates by June.

They expect an increase in FIIs' G-Sec limits to raise forex reserves. FIIs have almost entirely utilised their $25-billion limit. The report calls for doing away with the separate limit for Sovereign Wealth Funds, as these are not utilised since many of them invest through FIIs.

Finally, they continue to expect the RBI to hold the rupee at 58-62/USD. The rupee is seen settling at 62 a dollar in December, with the dollar settling at 1.25/euro. Softer oil prices and gold import curbs are offsetting the strong dollar, according to them.

COMMENT NOW