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    RBI needs to do long-term repo operations in 10-year segment


    The long end of G-sec yield curve has not participated in this rally.

    Long & Short of Bonds

    Murthy Nagarajan, Head- Fixed Income, Tata Mutual Fund

    Murthy has rich experience of more than 22 years in the financial services industry. Prior to his current assignment at Tata Asset Management, he had stints with Quantum AMC and with Mirae Asset Global Investment India as Head of Fixed Income for more than two years. Murthy holds a Master’s Degree in Commerce and completed his PGDBA from Somaiya Institute of Management & Research.

    In my previous article, I said the rally in AAA-rated corporate bonds will sustain this financial year. AAA-rated PSU bond minus government bond spread has come down to 40 to 60 basis points across maturities. The fall in the shorter end of the yield curve is largely due to RBI conducting long-term repo operations ( LTRO) and targeted long-term repo operations (TLTRO) for three-year maturity.

    Inflows of Rs 42,000 crore into debt mutual fund schemes in June and Rs 6.50 lakh crores liquidity surplus contributed to the sharp drop in yields. This bond rally is being witnessed across the corporate bond yield curve. Investors are chasing higher yields in the AAA-rated PSU space, as supply of papers has come down and demand has increased.

    The long end of G-sec yield curve has not participated in this rally. There are two main reasons for this: one, the supply of central and state government paper in the long end is expected to be high this financial year as well as in the coming years. Investors want a higher risk premium to buy these papers to cushion them against any unexpected volatility. We have instances in the past of long-term yield going lower after demonetisation and rebounding sharply by 100 basis points, causing mark-to-market losses to the holders of these bonds. The second reason is RBI’s LTRO and TLTRO in the short end of the yield curve, which has created demand for the securities in this tenor, bringing down yields.

    The Indian economy is expected to contract this financial year and growth is expected to remain low over the next few years. The government’s fiscal package to farmers, SMEs and industry has been only around 1 per cent of GDP, unlike other economies, which have given fiscal booster of around 10 per cent of their economies. The potential growth rate of the Indian economy has come down to below 6 per cent level, as many SMEs have closed down and corporates have put their investment plans on hold. To get out of the potential low growth rates, the government needs to do more structural reforms.

    Infrastructure investments, which will boost externality, should be undertaken on a priority basis in the coming years to boost potential growth rates. These projects will require long-term capital from the debt market.

    Government bonds in developed markets trading at negative yields are worth around $12 trillion. The Bank of Japan is targeting the 10-year yield curve, and does not allow it to go above 0.10 per cent. Many countries the world over have negative real interest rates, due to deliberate policies of their central banks to keep long-term interest rates low.

    Global inflation is expected to be low due to under-utilisation of capacity and high unemployment. In the Indian context, capacity utilization was below 75 per cent before the Covid-19 crisis. Expected long-term CPI inflation in India should be 4 per cent in the coming years, if not lower. At present, the 10-year bond yield is trading around 6 per cent, as the yield curve is steep over five years. The risk premium demanded by investors to buy 10-year over 5-year has increased to 90 basis points. The real interest rates demanded by investors to buy 10-year bond is 200 basis points compared with negative or zero rates in global markets.

    In the past, RBI has been doing open market operations (OMOs) to bring down the long end of the yield lower. However, this strategy has limited success, as market players have sold in OMO and purchased in the primary auction at higher yields .RBI needs to do LTRO at the long end of the yield curve to anchor the long-term rates in the economy. This will sustain the yields at the long end of the yield curve and not lead to undue spike in volatility due to excess government borrowings.

    Many countries in the world are targeting the long end of the yield curve to boost economy activity. This will give confidence to entrepreneurs and consumers and make commercial decisions, as they are assured benchmark interest rates will be low for long period of time. The central and state governments being the bigger borrowers in the market should be able to increase the tenor of their borrowings, which will lead to reduced gross borrowing in the coming years. This will create space for the private sector to borrow at favourable rates as and when demand pickup in the economy.
    (Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of
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