ANALYSIS. Why G-Sec yields have fallen below the 7% mark?

Investors have a lot to cheer for this year. Not just equity, but bond markets too are making a smart comeback.

On Monday, the yield on the 10-year government bond slipped below the 7 per cent mark, raking in tidy gains for bond investors (bond yield and prices have an inverse relationship).

From 7.7 per cent levels in the beginning of this year, yield on the 10-year G-Sec has fallen to 6.85 per cent, a nearly one percentage point fall.

Gilt funds that primarily invest in government bonds have made hay, gaining 12-13 per cent so far this year.

Through 2015, the yield on the 10-year government bond remained steady at 7.7-7.8 per cent, even as the RBI began to cut rates. Aside from the uncertainty over domestic and US rate movements, the yield on the G-sec was also ruling high owing to the demand-supply mismatch in G-Secs.

However, the yield started to trend lower since February this year, first on the back of the Centre’s adherence to the fiscal deficit target and then on the RBI’s 25-basis point rate cut in the April policy.

But what triggered the sharp fall over the past month or so was the RBI’s move to provide ample liquidity through more open market operations (OMOs) — buying of government bonds. This has helped suck out the excess supply of government bonds, leading to bond prices moving up and yields lower.

Market players were particularly concerned over the bout of volatility that may hit exchange rate and rupee liquidity in September, when the foreign currency non-resident (FCNR) deposits raised in 2013 came up for redemption.

But the RBI had maintained that it would continue to do more OMOs during the year to ensure ‘durable liquidity’. This to some extent appears to have provided a leg-up to the G-Sec market.

More than ₹80,000 crore of OMOs have been done by the RBI so far this year.

The RBI in its April policy had indicated that it would move from a deficit regime to a neutral liquidity regime to ensure quicker transmission of its policy rates to borrowers.

Infusing permanent liquidity into the banking system, through increased OMOs and other changes in the liquidity management such as lowering the rate corridor between the repo, reverse repo and marginal standing facility (MSF) rate, has also helped lower rates.

Liquidity adjustment facility (LAF) allows banks to borrow money from the RBI by selling securities with an agreement to repurchase the same.

Till April this year, the RBI kept the core liquidity deficit, the amount that banks borrow through the LAF, at about 1 per cent of net demand and time liabilities (NDTL) or deposits.

By addressing the short-term liquidity gap through term repos and longer liquidity deficit through OMOs, the RBI has been able to bring down banks’ reliance on the LAF window.

From an average borrowing of about ₹18,000 crore in April, LAF borrowing has significantly fallen to about ₹9,000 crore in the last two months.

To some extent, weak bank credit growth, which continues to be around 9 per cent, has also led to excess liquidity in the system.

The new 10-year government bonds maturing in 2026 were recently issued at a cut-off yield of 6.97 per cent, reflecting the easing liquidity conditions in the market. The yield on these bonds have also fallen to 6.85 per cent.

The redemption of the on-going FCNR deposits can however, lead to some bouts of volatility in the near term.

This is because the RBI has assured markets that it would supply dollars in case of sharp volatility in the rupee.

This may lead to a shortage of rupee liquidity as the RBI will be sucking out rupees to sell dollars. While the RBI has also assured adequate liquidity through more OMOs if need be (as is the case now), sudden disruptions cannot be ruled out. This can lead to yield moving up sharply in the interim.

Also, while the recent data on retail inflation offers some headroom for the RBI to cut rates, yield pick-up in the developed world leaves limited downside for Indian bond yields.

Last week, bond yields across global markets moved up sharply, as major central banks globally appear to be running out of stimulus measures.

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