Rally steams up bond market, gap between yields turns narrow

Rally steams up bond market, gap between yields turns narrow
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First Published: Thu, Feb 22 2007. 12 26 AM IST
Updated: Thu, Feb 22 2007. 12 26 AM IST
Successive rate hikes and even an increase in banks’ cash reserve ratio (CRR) have not been able to dampen the rally in the government bond market. The yield on 10-year government paper dropped to 7.92% on Wednesday as prices rose. This is despite Bank of Japan hiking its rate by a quarter percentage point to 0.5%. Normally a rate hike by any global bank impacts the Indian bond market.
“There is no surprise as the market is not reacting to domestic developments. After the Reserve Bank hiked the CRR in mid-February, the 10-year paper yield rose to 8.08%, but it has come down now even though liquidity is tightened and loan rates are rising,” says a bond dealer.
What is more, the gap in the yields on long-term and medium-term government paper is also narrowing. For instance, in August last year, when the yield on 10-year government bond was hovering around 7.94%, the yield on five-year government paper was 7.60%. In other words, the spread beween the 10-year and five-year paper was 34 basis points. One basis point is one 100th of a percentage point. On Wednesday, the spread narrowed down to five basis points as the five-year paper yield was 7.87% against the 10-year yield of 7.92%.
The reason behind such “distortions” is the shortage of government papers in the market. Banks are forced to make investments in governmentsecurities or gilts to maintain statutory liquidity requirements.
Under the law, banks have to invest 25% of their deposits in gilts.
“Their deposits are growing and they need to invest more in government bonds. So banks are not really bothered whether they are investing in a five-year or a 10-year paper. This is distorting the yield curve,” says another bond dealer. A senior banker points out that they are staying away from long-term bonds beyond 10 years.
“There was a considerable drop in demand after talks of bank’s minimum requirement of investment in government bonds could be brought down from the current 25% level. If this were to happen, banks who are fast approaching the 25% level, would find gilts unattractive.
The 10-year paper yield touched the 8% mark and even crossed it, but stabilized after RBI indicated that it would keep a tight check over liquidity,” says Ashish Parthasarthy, head of trading at HDFC Bank. He does not expect the floor for investment in government bonds to come down very soon.
Banking analysts too feel that it is unlikely that RBI will fix the liquidity floor below 25% too soon as this will give banks more resources to lend. So, the “distortions” in the bond market is here to stay, at least for the time being.
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First Published: Thu, Feb 22 2007. 12 26 AM IST
More Topics: Money Matters | Bonds |