RBI kept the interest rates unchanged on concerns of growth & liquidity issue. As bond shares inverse relationship with the interest rates, it becomes important to understand the concept clearly before investing in fixed income. Financial advisor Arjun Parthasarathy enlightens us on how the yield curves behave with the rise/fall of interest rates.
The yield curve plots the yields of fixed income securities with their maturities. A normal yield curve is upward sloping on the theory that fixed income securities with shorter maturities trade at yields lower than that of yields of fixed income securities with longer maturities. For example a five year government bond yield should be lower than a ten year government bond yield, as per theory. In practice, yield curves change shape due to various factors, and there are times when the five year government bond yield is higher than the ten year government bond yield and when this happens the yield curve is said to be inverted.
India has been facing inverted yields curves in the government bond market, corporate bond market and interest rate swap market for over a year now. The chart below shows the inverted nature of yield curves for government bonds, corporate bonds and interest rate swaps (OIS or Overnight Index Swaps).
Government bond yield curve is inverted over the five over ten segment of the curve with the five year government bond yields at 8.24% levels higher than ten year government bond yields at 8.11% levels. This inversion can to some extent be explained by the fact that the ten year government bond is a new benchmark on the run bond, which is the 8.15% 2022 bond while there is no five year benchmark bond that has been issued recently. However the fact remains that even if a new five year bond was to be issued, it will trade at similar or higher yields than the ten year bond.
Corporate bond yield curve is inverted with one year corporate bond yields at 9.6% levels trading higher than five and ten year corporate bond yields of 9.35% to 9.40% levels while the OIS curve is inverted with the five year OIS yield at 7.30% levels trading below one year OIS yield of 7.80% levels.
The reason yield curves are inverted is that repo rate is at 8% and banks are borrowing on a daily basis from the RBI at repo rates. Liquidity is in deficit and RBI has kept the repo rate at 8% in its June policy review leading to short maturity bond/swap yields trading levels higher than long maturity bond/swap yields. The longer maturity bond/swap yields are lower than short maturity bond/swap yields on expectations of RBI reducing repo rates down the line and liquidity becoming easier going forward.
At some point of time in the future the view of the market will turn out right i.e. RBI will cut repo rates and liquidity will ease. Once repo rates are cut and liquidity eases, the yield curves will steepen with short maturity bond/swap yields trading at levels below longer maturity bond swap/yields.
The shift in yield curves from inverted to steep will benefit investors at the short end of the yield curve. Investors investing in bonds of maturities of one and five years or investing in short term funds can see good gains as yields on such bonds fall. However the timing of the steepening of the yield curves is not certain as RBI is still holding on to rates and liquidity is still negative.
The actions of the RBI point towards steepening as it has cut repo rates by 50bps in its April 2012 policy and has indicated further cuts ahead on growth issues. RBI is buying government bonds (it has bought Rs 67,000 crores of bonds April till date and is buying more through bond purchase auctions) and this bond purchases will lead to liquidity deficits easing down the line.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.