India starts to develop yield curve as trading shifts from 10-year bonds

By Neha Dasgupta and Swati Bhat

MUMBAI (Reuters) - Government bond markets are experiencing a rare sight: a yield curve driven by strong investor buying in maturities other than the traditional benchmark 10-year government bond.

Driving the buying in non-10-year Indian debt is the prospects of an economic recovery and a commitment by the governor of the Reserve Bank of India (RBI), Raghuram Rajan, to lower inflation.

But whether this trend continues will depend on the central bank - how it chooses to raise debt to fund the country's fiscal deficit, analysts say.

The central bank will have to nurture the market by issuing debt strategically to build liquidity outside of the 10-year bond.

Ten-year bonds have long been the easiest for the RBI to sell because they are popular with banks due to higher liquidity and their ease of trading.

Demand for Indian bonds has been strong this year among foreign investors, attracted by the higher returns on Indian bonds against other emerging market counterparts and U.S. bonds. A lower current account deficit and stabilising economic fundamentals have also underpinned interest in India's sovereign bonds.

Market conviction that Rajan will succeed in reducing consumer inflation to 6 percent by January 2016 from 7.8 percent in August has sparked a rally in 10-year government bonds, pushing yields down 35 basis points this year.

The rally in the benchmark, however, has made it too expensive for many investors who have shifted into other tenors.

Demand for longer-dated bonds maturing 2028 issued in May and shorter-dated 2020 bonds issued in June, has helped to create a yield curve.

Trade in 14-year bonds totalled 2.44 trillion rupees ($40.14 billion) as of the end of August, making it the third-most traded debt over the past few months, data from the Clearing Corp of India showed. In unusual activity, the 14-year bond saw more trading action than the 10-year bond on some days.

Rising expectations the central bank may cut interest rates next year as inflation wanes are supporting demand for bonds. Foreign financial institutions have bought a net $18.7 billion in debt compared with $14.2 billion in equities so far this calendar year, regulatory data shows.

Still, some analysts are sceptical the RBI will help develop the curve as it has seldom tried to do this even though it could deepen debt markets, lower funding costs and provide a useful pricing benchmark for Indian companies' own fund-raising.

"The yield curve surely needs to develop more; liquidity across securities needs to increase. It is going to be a medium-term process, but the RBI issuing more benchmark tenors is useful," said Kumar Rachapudi, senior rates strategist at ANZ in Singapore.

The Indian yield curve has more room to develop because, unlike curves in more developed economies, there is very little trading in debt longer than 15 years.

The government needs to raise a hefty 6 trillion Indian rupees ($98.2 billion) by March 2015, more than the 5.6 trillion rupees raised the previous year. The RBI, who acts on behalf of the government, might be tempted to fall back on its familiar strategy of issuing heavily in tenors up to 14 years.

"The RBI has to offer bonds that sell. They can choose to experiment in an attempt to develop the yield curve but they have to cover the government's borrowing needs," said Piyush Wadhwa, head of trading at IDFC Ltd in Mumbai.

($1 = 61.1300 Indian rupee)

(Editing by Rafael Nam and Jacqueline Wong)