The Impact Of Rising Bond Yields And Options Before Rbi

Why are bond yields rising now?

India’s benchmark bond yields touched 7% on 8 April, after the monetary policy committee of the RBI indicated its intent to gradually withdraw surplus liquidity. Then came the abrupt rate hike on 4 May, and the benchmark bond yield further hardened to 7.38%. The reasons: A surge in global oil prices, high inflation and a large government borrowing programme. The rate-setting committee is expected to hike rates again, depending on the April inflation numbers, amid volatility in the geopolitical sphere. To be sure, the benchmark yield ended 17 bps lower on Tuesday amid a drop in oil prices.

What does the government want?

The government reportedly wants the central bank to buy back government securities (G-Secs), a move that might lead to tempering of yields from the current levels. To be sure, in its role as the government’s debt manager, RBI looks at minimizing the cost of government borrowing. Higher bond yields lead to costlier borrowing for the government. They also raise the borrowing cost for corporates tapping debt markets, as the corporate bond market tracks the movement in G-sec yields. A higher cost of capital impacts the profitability of companies and affects the investment cycle.

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How does rising bond yields affect banks?

Banks are the largest holders of government securities, including state development loans (SDLs) and treasury bills. Therefore, any volatility in the bond market is expected to hit their income. Not only do they have to set aside marked-to-market provisions for the fall in bond prices, they also make losses while selling such investments.

What are the options before RBI?

Typically, the option is to purchase government bonds through open market operations. Experts say it is difficult to do that now when the central bank is in a monetary tightening mode. Still, RBI could use Operation Twist, under which it sells short-term bonds and buys long-term securities, making the whole operation liquidity-neutral. This brings down long-term yields, while short-term yields go up. In the past, Operation Twist has helped reduce the term spread between 10-year and one-year bonds, flattening the yield curve.

How will bond yields move from now?

The 10-year benchmark bond yield is now expected to stay above 7.5% in the current FY. Economists at Bank of Baroda believe the pressure on bond yields will continue and the benchmark will move in the range of 7.5-7.75% in FY23. Economists also expect another 50-75 basis points of repo rate hikes this fiscal in order to quell inflationary pressures. Retail inflation has already been above the monetary policy committee’s flexible target of 2-6% in January, February and March, and is unlikely to be benign in April.