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Yields Drop to Historic Lows

While yields are likely to test the 9% level, liquidity overhang in the system could prompt RBI to step in to mop-up the excess

Yields tanked to historical lows this week as a liquidity flush market bid up bond prices. The benchmark 10-year paper dropped to 9.08 per cent with deposit-saddled banks left with little option but to invest in government securities. Apart from a 25 basis points rate cut in the US, the immediate trigger came from the redemption of 2001 government bond, which has injected Rs 8,100 crore into the system. Further, another Rs 600 crore are due from coupon inflows. On the other hand, the government has refrained from fresh borrowings after it received a hefty dividend from RBI last week.

With ample money supply, call rates hovered around 7 per cent with most players covering their position ahead of the reporting Friday. The rupee was also stable against the dollar even as the greenback continues to weaken against most currencies. The RBI is believed to be mopping up excess dollars in the system in order to maintain the currency equilibrium at current levels. Meanwhile, banks continue to pare deposit rates with the cut ranging from 25 to 50 basis points. If deposit rates are not reduced, it will lead to an asset-liability mismatch as yields on investments have taken a sharp dip.

Falling Dollar – Pitfalls Ahead? With an elusive US recovery and the dollar on decline against major world currencies, the moot point is whether investors holding dollar-denominated investments will now seek higher returns elsewhere. A falling dollar means that the value of holdings (when converted to another currency) continues to go down. Further, the spate of rate cuts in the US in the current calendar has pulled down interest rates to 3.5 per cent. However, investors typically favour currencies of nations with higher interest rates since it offers better returns. On the other hand, an appreciation of domestic currency against the dollar is not liked by most nations since it hurts exports to the US. This is especially critical in the current scenario when demand is already low in the US and most economies face a slowdown. Thus, central banks may even "talk down" their currencies. While an immediate sell-off is unlikely unless dollar sees a sharp fall, fresh money may now move to countries with higher returns and a similar risk profile.

Outlook With positive sentiment and government unlikely to borrow next week, yields are likely to test the 9% level. However, the liquidity overhang in the system could prompt RBI to usher in OMOs and rein in an excessive built-up in prices. The government is also expected to aggressively resume borrowing early next month and hence, yields could further move up. While returns on bond funds have perked up after slipping in early August, investors are now clearly wary of current levels with most money is pouring in cash funds.

The falling yields have ensured a bias towards the short-end with little reward for investing at the longer end of the yield curve. For instance, the yield on 11.15%, 2002 paper is 7.07 per cent against 7.61 per cent for the 11%, 2006 year paper – an excess return of only 54 basis points! This surely looks unsustainable and short-term interest rates should go down. Further, buying could again emerge in relatively illiquid sovereign bonds, which offer a higher return for a similar time horizon. The corporate bond yield curve has fallen at a slower pace, translating into higher spreads over government securities. Thus, corporate bonds offer an attractive investment opportunity with the spread around 130 basis points. Further, fresh corporate bond issues could hit the market with yields at historic lows.