Lhe last few months have been marked by considerable volatility in the bond market. Investors, both domestic and foreign, appear to have become more risk averse amid heightened uncertainty. Trading activity in the bond market saw a visible decline in October.
Sustained monetary policy tightening by the US Federal Reserve led to a narrowing of the yield spread between Indian and US bonds. As a result, foreign ownership of Indian government and sovereign bonds has fallen to record lows.
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REIT ownership of bonds
Aggressive monetary policy tightening led to a surge in yields in the US, UK and other advanced economies. While monetary policy has also tightened domestically, the pace of tightening in advanced economies has exceeded that of India. This led to a narrowing of the yield gap (yield differential).
For example, the difference between the Indian 10-year bond yield and the US 10-year bond yield was 4.94% in December 2021. It narrowed to 3.47% in October 2022. On November 2, the US Fed announced the fourth straight 75 basis point rate hike and hinted that more rate hikes are in store. This will affect the yield spread over the next few months.
Reflecting the impact of the narrowing yield spread, Foreign Portfolio Investor (FPI) holdings in Indian government and corporate bonds plummeted. Of the total limit available for investments in government bonds, REITs used less than 25% government bonds.
In the case of corporate bonds, the limit used is even lower at 17 percent. The depreciation of the local currency has also caused foreign investors to exit local debt securities. Emerging economies like Brazil, whose currency has appreciated against the dollar, offer better yields on their bonds to foreign investors than Indian bonds.
REITs became leveraged net sellers by selling $432 million worth of debt in October. REITs will likely turn to sustained buying only when there are signs of a slowdown in the aggressive tightening of monetary policy by the US Fed.
Bond yield trajectory
During the pandemic, the RBI injected liquidity through its bond buying programme. Since October 2021, he has stopped the program. It withdrew liquidity through variable rate reverse repo (VRRR) auctions.
Since May 2022, the RBI has raised the policy rate to combat rising inflation. Central bank actions directly affect short-term interest rates. For example, the yield on one-year government bonds rose from 5.1% at the start of May to 7% at the end of October. By contrast, the longer-term bond yield rose relatively moderately, from 7.1% at the start of May to 7.4-7.5% at the end of October.
Rate hikes have led to lower demand from traders – private and foreign banks, primary traders and foreign portfolio investors prefer to adopt a policy of wait and watch until more clarity emerges on the rate hikes by the RBI.
Liquidity of the banking system
Another factor that has influenced the appetite for bonds in recent months has been the decrease in liquidity in the banking system. The sustained rise in bank credit, further bolstered by increased demand during the holiday season, tax outflows and RBI intervention in the cash market to stem the fall in the rupee led to the drying up of liquidity in the banking system. Banks raised funds through the overnight interbank money market. The surge in demand for funds led to a spike in the weighted average call rate. Banks also tap into other sources such as certificates of deposit and term deposits to raise funds.
Banks’ incremental credit-to-deposit ratio, or the proportion of new deposits mobilizing for new lending, jumped to 135% as of Oct. 21. This indicates that banks are tapping into their bond portfolio to meet credit demand. The sale of bonds by banks is likely to push bond yields higher. As a result, the incremental investment deposit ratio is experiencing a decline, indicating that banks are slowing down bond investments.
Some of the volatility in bond yields can also be attributed to the delay in including local bonds in global bond indices. In September, in anticipation of the inclusion of Indian government bonds in global bond indices, investor participation in Indian bonds increased. But bond inclusion reports delayed to next year also likely led to subdued investor interest in October.
Bond market trading activity
Government bond trading activity saw a visible decline in October. Market Liquidity Indicators data from the Clearing Corporation of India Limited (CCIL) shows that the average number of trades in government bonds, including government bonds, fell to 2 from 6,593 in September. 664 in October.
Other de facto liquidity indicators such as the bid-ask spread (the amount by which the ask price exceeds the bid price) for liquid securities and the impact cost also increased from September to October.
How are returns likely to evolve?
Markets have already priced in another 35 to 50 basis point rate hike this year. Much of the rate hikes have already taken place. While short-term yields could rise slightly with further rate hikes by the RBI, the longer-term yield (10-year bond yield) is unlikely to rise above 7.5%, unless it there is an unforeseen shock in the market. In short, the movement in yields should be more limited going forward.
Radhika Pandey is a consultant at the National Institute of Public Finance and Policy.
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