10 min read.Updated: 04 Mar 2021, 05:40 AM ISTAparna Iyer
The RBI governor’s attempt to draw a line in the sand on yield curve is not going down well with the bond market
The RBI cannot stop or even slow down the rise in yields without purchasing bonds. But by doing so, it ends up infusing more liquidity at a time when it is trying to signal normalizing liquidity.
Warren Buffett has called the future of bond investors bleak in his recent annual letter to investors. The legendary American investor’s warning follows the bond market tantrum globally when US yields rose to the highest in one year and spooked markets across geographies.
While Buffett sounds downbeat, Shaktikanta Das, India’s central bank governor, is optimistic. He has reminded the bond market that the yield curve is a public good—surplus liquidity, low policy rates and weak economic growth warrant that yields do not rise sharply. Yield curve refers to the interest rate associated with different tenures of sovereign bonds.
But the bond market believes that the central bank is asking too much from it.
The Reserve Bank of India (RBI) not only wants the market to absorb a humongous bond supply but also wants it to settle for a lower price like a thrift store owner. The trigger for this belief came from the devolvement of the 18 February auction on primary dealers.
The central government borrows through bond auctions which the RBI conducts. The devolvement of an auction is to make a bunch of investors forcibly buy the bonds because of low demand.
To be sure, the buyers are underwriters that are mandated to take the supply in case of a shortfall in demand for bonds. Nevertheless, the outcome of a devolvement in most cases is a mark-to-market loss on the books at the very least (when bond yields rise, prices fall, resulting in a mark-to-market loss for investors). No one likes losses and the resultant hit on sentiment crimps appetite for bonds.
Of course, the piling losses are not restricted to just Indian bond investors. US Treasury bond yields are climbing mainly because of a large $2-trillion stimulus package in the works. Since dollar-denominated safe-haven treasuries are rising, it means funds would flow towards them and leave out sovereign bonds in other countries. That’s why stock markets globally have been nervous.
Thanks to unprecedented fiscal expansion, the chain reaction of yields rallying everywhere has now set in.
The RBI’s message on the sovereign bond yield curve has undergone a change under Das. The RBI governor has implored the market to assist in the “orderly evolution of the yield curve." In other words, Das wants bond yields to not surge because there is no need for them to. The governor isn’t altogether wrong here.
The system’s liquidity is around ₹8 trillion in surplus. What’s more is that this surplus is available at low rates. Most money market yields are near the policy repo rate of 4% which itself has been reduced by 115 basis points over the past one year. One basis point is one-hundredth of a percentage point.
The liquidity surplus is unprecedented and puts additional pressure on market yields. Long-term government bond yields are still 15-20 bps lower than a year ago despite the recent rise.
While bond traders contend with these reasons, they point out that the RBI has got it wrong in one aspect. “The players in the market have a defined appetite and the RBI has to acknowledge that. When they make a loss, this appetite is hit at least for the short-term. This is what we are seeing now," said the head of treasury at a private sector bank requesting anonymity.
Here is an example. When the 18 February bond auction devolved, it reflected the low appetite for bonds. All successful bidders would get allotment at the cutoff yield or the level at which they bid if it is lower. The cutoff yield was set at 6.059% for the 10-year bond at the auction. The bond had settled at 6.03% the previous day in the secondary market. Post devolvement, the yield surged to end at 6.13% on the auction day. It rose further on 21 February to touch 6.20% as underwriters decided to offload the newly acquired stock.
According to bond traders, one disappointment was that the central bank did not step in as a buyer despite flashing signals that there is lack of appetite. “If you want the yield to be at a certain level, you need to do all it takes to make sure that happens. Then you cannot be bothered by what it would do to liquidity. Let the objective be clear," said the treasury official quoted above.
But some believe that active yield management is a dangerous road for the RBI to go down. “It is a myth that RBI can draw any credible ‘line in the sand’ with respect to the level of the 10-year bond yield. This is yield curve control (YCC) which is strictly the domain of developed market central banks, and only a handful there as well," wrote Suyash Choudhary, head of fixed income at IDFC Mutual Fund in a note to clients.
Choudhary argues that the RBI can only slow the speed of increase in yields. Perhaps the central bank is aware of this. The appeal for an orderly evolution of the yield curve by governor Das indicates that the central bank won’t be averse to rising yields.
But treasury losses and mark-to-market hits are just the symptoms and the bond market’s actual troubles are deeper.
At the heart of the problem with yields is the disproportionate rise in supply and a growing fatigue from investors to buy bonds. In the current financial year, the sovereign bond supply will end up being 79% more than what it was in FY20. Note that the government announced an extra borrowing of ₹80,000 crore in February. It has also borrowed ₹1.1 trillion to plug the shortfall in goods and services tax compensation. All this has taken the supply of central government paper to over ₹13 trillion this year.
Then, there is the supply from state governments too. States will end up issuing a little over ₹8 trillion worth of bonds, taking the total supply of sovereign paper to over ₹20 trillion this year. The upcoming financial year won’t see a sharp drop in bond supply from the central government since the borrowing is budgeted to be ₹12.1 trillion. States too are expected to borrow a large amount.
Bond traders are worried that the biggest buyers of bonds—banks—won’t be able to swallow bonds like they did this year. Lending to the private sector is expected to pick up and the incentive to put money into safe and low-yielding bonds will reduce. With economic recovery, lenders would look more towards giving out loans to companies. Analysts at Crisil Ltd estimate credit growth to jump by 4-5 percentage points next fiscal year to 9-10%. That means less liquidity left to lend to the government.
Moreover, banks were allowed to keep their new bond purchases in a held-to-maturity bucket which prevents mark-to-market losses. While the mandated HTM holding is 19.5%, this was increased to 22%. This leeway will end in four quarters, another reason bond traders are looking away from long-term securities today. “We may have overestimated the depth of the market," said Choudhary of IDFC Mutual Fund.
Domestic investors may shrink their purse next year but foreign investors have already done so. Foreign institutional investors do not want to touch Indian sovereign bonds as seen by the low levels of utilisation of investment limits. As of February, the foreign investment limit for government bonds was used only up to 40%. Foreign investors have been big sellers of bonds in the past year and the trend is unlikely to change this year.
The one reason spooking both foreign and domestic investors is the rise in inflation, an offshoot of unprecedented central bank easing in advanced economies.
The reflation train
The dearth of dollars into the domestic bond market has to do with the upswing in the global reflation trade—when economic growth as well as inflation are accelerating. Bond yields globally are climbing a steep slope. The benchmark US treasury yield touched 1.61% last week, the highest in a year and bond auctions there have seen tepid demand.
The stimulus announcement by the US government has added fire to expectations of a rise in inflation there even as the fixed income market braces for a choking of supply. As such, the liquidity infusion by the US Federal Reserve and other central banks over time has boosted commodity prices. From oil to gold, prices of most commodities have risen sharply in the last couple of months.
The rise in inflation worldwide poses two challenges for India. Besides the direct sentimental impact, bond markets in emerging economies such as India run the risk of capital outflows.
As US assets begin to yield more, global funds may rejig their allocations to fixed income in emerging markets. In fact, US treasury yields have already spooked even equity markets across the globe in anticipation of dollar outflows. India stands to lose more given that inflation here is higher compared with most other emerging market peers.
That brings us to the other effect of rising commodity prices. They put pressure on inflation back home through the import channel. The effects are already visible on rising input costs for companies that would soon get passed onto consumers. As such, the RBI expects headline retail inflation to be above 5% in the first half of FY22.
Bond investors cannot ignore the effects of price rise on interest rates. Policy rate hikes may be the last move by the RBI in its path towards normalisation. Economists believe that the central bank won’t hike rates until the end of FY22 and would first begin to withdraw the excess liquidity surplus.
But markets being markets, bond yields are pricing in a rise in interest rates well ahead of any policy hike. This makes flattening the yield curve challenging for the RBI.
“There is a case for flattening the yield curve. Short-term yields are below inflation rate but those beyond 10-year are already elevated," said R. Sivakumar, head of fixed income at Axis Mutual Fund. He added that the RBI runs the risk of distorting the yield curve if it begins to use OMOs (a tool through which the RBI buys government bonds from the open market) for active yield management.
Spoiling the path
Bond investors want the RBI to stand as a big buyer of government paper to help them absorb the increase in bond supply in FY21. Given that states too have jacked up their borrowing for the current financial year, investors are already struggling to digest the incessant bond supply.
But the RBI knows it is a dangerous game to keep the floodgates of its balance sheet open to bond purchases especially when it has indicated normalising liquidity. OMO has been touted as a liquidity tool with yield implications. Therein lies the RBI’s dichotomy. The central bank cannot stop or even slow the rise in yields without purchasing bonds. But by doing so it ends up infusing more liquidity when it is trying to increase short-term rates at the same time.
“The RBI’s dilemma is not as much on the objective but more in the choice of tools to achieve it," said Soumyajit Niyogi, associate director Credit & Market Research at India Ratings Ltd.
Since it cannot be a guaranteed large buyer of government bonds, the central bank has used a variety of tools to manage both yields and liquidity. The RBI has used tactical tools such as the variable reverse repo under its liquidity adjustment facility (LAF) to push up short-term yields through liquidity sterilisation.
It has bought long-term bonds and simultaneously sold short-term bonds through operation twist auctions in a bid to flatten the yield curve.
To be sure, it has continued with its outright bond purchases under OMO too, albeit not to the extent the market wants. Recently, the central bank made a pitch to bring back market stabilisation scheme (MSS) bonds to mop up liquidity. These bonds were earlier used to sterilise liquidity infused through the central bank’s forex interventions. Such bonds are typically 2-3 years in tenure.
While the RBI’s LAF operations, its operation twists and its move to normalise the cash reserve ratio (CRR) by May shows it wants liquidity surplus to reduce, its continued forex interventions and bond purchases result in just the opposite. Further, comments from Governor Das have always been in favour of keeping liquidity in surplus.
No wonder bond traders are split in their interpretation of what lies ahead. The RBI has been trying every possible trick to keep yields from rising.
But perhaps Das should heed another advice from Buffett. Never test the depth of the river with both feet.
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