Markets | The sweet spot in bond yields

The yield curve has turned steeper in India over the past one year. The spread between the yield on 10-year bonds and 1-year government paper has increased from 55 basis points in April 2018 to 90 basis points (7.41 percent yield on 10-year government bonds minus 6.51 percent for 1-year bond) now. This essentially means that short term money is far cheaper than long term money now.

Generally, the steepening of the yield curve is driven by a rise in inflation or inflationary expectations. But that’s not the case now. In fact, the retail inflation has remained soft for many months now. What’s more, wholesale inflation has also shown signs of softening in the last month.

The steepening of the yield curve is good for the economy since the yields have not gone up. In fact, there is a decline in yields both at short and long end of the curve. The increase in term spread is due to far higher decline in yields of the short term bonds as compared to medium to long tenure bonds, resulting in steeper yield curve.

The most plausible explanation for the far greater softness in short term rates could be attributed to measures taken by the Reserve Bank of India and policy makers to ease liquidity conditions. RBI infused close to Rs 3 trillion in money markets through open market operations (OMO) last fiscal. The action was prompted by compulsion to contain the impact of the IL&FS fiasco in the money markets. Also, the policy makers needed to address the concerns related to slowdown in consumption and industrial activity lately.

On the other hand, the fairly aggressive borrowing plan by the central government has kept pressure on long term interest rates. The gross borrowings by the government planned for the current fiscal year stands at Rs 7.1 trillion compared to Rs 5.87 trillion last fiscal (FY 2018-19).

Also, the quantum of OMO could be much lower this fiscal and consequently, there would be weaker demand for bonds of medium to long tenure. So the yield curve could remain steep or even steepen further in the near term.  The higher term spread from short term to medium/long term tenure is desirable for the bond market and to create  a supportive environment for fresh issuances in the corporate bond market.

Given this scenario, the 1 to 3 year period on the yield curve continues to be in the sweet spot and the only place to hide in the fixed income market. Money flow to fixed maturity plans (FMP) could dry up given the recent unpleasant experience and possibly find their way into short term funds especially those with exposure to high credit quality paper.