Financial Daily from THE HINDU group of publications
Sunday, Jun 30, 2002
Money & Banking - Debt Market
Bonds carry limited upside
THE yield curve shifted downwards week-on-week. The 10-year bond yield, for instance, fell 25 bps over the previous week. Going forward, the bonds carry an upward bias. Consider the reasons.
First, the RBI cut the repo rate by 25 bps to 5.75 per cent. The excess money in the system may find its way into the bond market, as banks may find it less attractive to lend to the RBI.
Dealers may, however, be wary of keeping bonds sharply bid, as the RBI may then engage in OMOs to stablise yields.
Second, bonds appear pricey across maturity sectors based on the forward yield curve. The seven-year bond, especially, appears very rich.
At present, only the 10-year bond appears cheap, despite the fall in yields. It is therefore a moot point whether bond dealers will sharply bid up prices from the current levels, notwithstanding the cut in the repo rates.
Third, the front-end of the yield curve is flat. A primary reason for the curve shape is the rally in the short-term yields. The spreads between the one and the two-year bonds, for instance, fell 16 bps over the previous week.
The flattening of the yield curve has resulted in the short-term spreads (yield differential between the 10-year and 2-year bond) falling to just 78 bps, just 4 bps more than the long-term spreads (yield differential between 20-year and 10-year bonds).
Typically, short-term spreads are far higher than long-term spreads, for various reasons. For instance, higher convexity bias of long-term bonds tends to flatten the yield curve at the long-end, thereby narrowing the long-term spreads.
Given that the short and long-term spreads are similar, it may be that bonds at the short-end are rich. And since bond dealers are not likely to be keen in building their trading book with just long-term bonds, the upside from the current levels may be limited.
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