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Need for Long Term Repo operations by RBI in the Ten year segment

Murthy Nagarajan

By Murthy Nagarajan,
Head-Fixed Income, Tata Mutual Fund

Need for Long Term Repo operations by RBI in the Ten year segment

In my previous article, I have said AAA corporate bond rally to sustain in the current financial year. AAA PSU bond minus government bond spread has come down to 40 to 60 basis points across maturities. The fall in the shorter end of the yield curve is largely due to RBI conducting, Long Term Repo Operations ( LTRO) and Targeted Long-Term Repo Operations (TLTRO)  for 3-year maturity. Inflows of Rs 42,000 Crores in debt mutual fund schemes in the month of June and liquidity surplus of Rs 6.50 Lakh crores, contributed to the sharp fall in yields. This bond rally is witnessed across the corporate bond yield curve. Investors are chasing higher yields in the AAA PSU space as supply of papers have come down and demand has increased.

The long end of G-sec yield curve has not participated in this rally. There are two main reason for this - one the supply of central and state government paper in the long end is expected to be high in this financial year as well as the coming years. Investors want a higher risk premium for buying these papers to cushion them against any unexpected volatility. We have instance in the past of long-term yield going lower after demonitisation and rebounding sharply by 100 basis points, giving mark to market losses to the holders of these bonds. The second reason is RBI has done LTRO and TLTRO operations in the short end of the yield curve, which created a demand for the securities in this tenor, bringing down the yields.  

The Indian economy is expected to contract in the current financial year and growth is expected to remain low for the next few years. The Government fiscal package to its farmers, SME and industry is only around 1 % of GDP unlike other economies which has given fiscal boost which is around 10 % of the economy.  The potential growth rate of the Indian economy has come down to below 6 % levels as many SME have close down or the investment plans of corporates have been put on hold. To get out of the low potential growth rates, Government needs to do more structural reforms.  Infrastructure investments which will boost externality should be undertaken by the government/private sector on a priority basis in the coming years to boost potential growth rates. These projects will require long term capital from the debt markets.

In my previous article, I have said AAA corporate bond rally to sustain in the current financial year. AAA PSU bond minus government bond spread has come down to 40 to 60 basis points across maturities. The fall in the shorter end of the yield curve is largely due to RBI conducting, Long Term Repo Operations ( LTRO) and Targeted Long-Term Repo Operations (TLTRO)  for 3-year maturity. Inflows of Rs 42,000 Crores in debt mutual fund schemes in the month of June and liquidity surplus of Rs 6.50 Lakh crores, contributed to the sharp fall in yields. This bond rally is witnessed across the corporate bond yield curve. Investors are chasing higher yields in the AAA PSU space as supply of papers have come down and demand has increased.

The long end of G-sec yield curve has not participated in this rally. There are two main reason for this - one the supply of central and state government paper in the long end is expected to be high in this financial year as well as the coming years. Investors want a higher risk premium for buying these papers to cushion them against any unexpected volatility. We have instance in the past of long-term yield going lower after demonitisation and rebounding sharply by 100 basis points, giving mark to market losses to the holders of these bonds. The second reason is RBI has done LTRO and TLTRO operations in the short end of the yield curve, which created a demand for the securities in this tenor, bringing down the yields.  

The Indian economy is expected to contract in the current financial year and growth is expected to remain low for the next few years. The Government fiscal package to its farmers, SME and industry is only around 1 % of GDP unlike other economies which has given fiscal boost which is around 10 % of the economy.  The potential growth rate of the Indian economy has come down to below 6 % levels as many SME have close down or the investment plans of corporates have been put on hold. To get out of the low potential growth rates, Government needs to do more structural reforms.  Infrastructure investments which will boost externality should be undertaken by the government/private sector on a priority basis in the coming years to boost potential growth rates. These projects will require long term capital from the debt markets.

Government bonds in developed markets trading at negative yields is around 12 trillion USD. The Bank of Japan, targets the 10-year yield curve and does not allow it to go above 0.10 %. Many countries in the world have negative real interest rates, due to deliberate policy of the Central Bank to keep long term interest rate low. Global inflation is expected to be low due to underutilization of capacity and high unemployment.  In the Indian context, capacity utilization was below 75 % before the outbreak of Covid-19. Expected long term CPI inflation in India should be 4 % in the coming years, if not lower. At present, the 10-year bond yield is trading around 6 % levels as the yield curve is steep over 5 years. The risk premium demanded by investors to buy 10 year over 5 year has increased to 90 basis points. The real interest rates demanded by investors to buy 10 year is 200 basis points compared to negative or zero situation in global markets.

RBI in the past has been doing Open Market Operations (OMO) to bring down the long end of the yield lower. However, this strategy, has limited success as market players have sold in OMO and purchased in the primary auction at higher yields .RBI need to do LTRO in the long end of the yield curve to anchor the long-term rates in the economy. This will sustain the yields at the long end of the yield curve and not lead to undue volatility spikes due to excess government borrowings. Many countries in the world are targeting the long end of the yield curve to boost economy activity. This will give confidence to entrepreneurs and consumers and make commercial decisions as they are assured benchmark interest rates will be low for long period of time. The Central and State Government being the bigger borrower in the markets should be able to increase the tenor of their borrowings, which will lead to reduced gross borrowing in the coming years. This will create space for the private sector to borrow at favourable rates as and when demand pick up in the economy.

Disclaimer: The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. The views expressed are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Asset Management will not be liable in any manner for the consequences of such action taken by you. Please consult your Financial/Investment Adviser before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund.

 

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