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THE yield curve has marginally shifted downwards in the last fortnight. The ten-year bond currently trades at 7.12 per cent, 5 bps lower than a fortnight ago. Going forward, the bond market may remain bullish, though the upside from the current levels may be limited.

Consider the factors: First, the 91-day T-bill yield fell below the repo rate in the auction held on September 4. The market, therefore, expects the RBI to cut the repo rate, a measure that will reiterate softer interest rate environment.

This will not, however, enthuse bond dealers to sharply bid up prices. The reason is that the RBI has been frequently holding OMOs to moderate liquidity in the system; sharply bidding up bonds will also result in sharp fall in prices should the RBI aggressively engage in OMOs.

Second, the long-end of the yield curve has flattened further. The yield differential between the 30-year and the 10-year bond is 70 bps. On the other hand, the yield differential at the short-end, between the 10-year and the 2-year bonds, has increased to 120 bps.

Even accounting for the high convexity bias on long-term bonds, the yield differential at the long-ends appears unsustainable. This provides small room for bond dealers to bid long-term bonds.

Third, most maturity sectors are trading rich in terms of the forward yield curve; only the 7-year and the 2-year bonds appear cheap. This may, of course, be a function of low liquidity in these bonds. The moot point is whether the bond dealers will be willing to sharply bid up prices despite the local richness of the other maturity sectors. That seems unlikely, as bidding up prices further will only expose their trading book to higher market risk.

Finally, the twin auctions for the 15-year and 20-year bonds scheduled to be held on September 9 for a combined notified amount of Rs 5,000 crore could steer the sentiment in the bond market for the coming week. In all, bonds are likely to remain bid, but the upside may be limited.

B. Venkatesh

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