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Bond prices are falling these days, and the yield trend has reversed. This is making banks nervous. By Ashish Gupta
For most of 2002-03, demand for Indian government bonds was on an upward incline, with banks and other bodies piling them high. Higher demand spells higher prices in the secondary market, accompanied naturally by a fall in 'yields' (simple: if you pay more for a fixed-return asset, your percentage return from that very asset will be less, relative to what you pay). Then came the war jitters, and all of a sudden - over the past three weeks or so - the trend reversed. Bond prices have been falling, and the yields (used as the key indicator because of its link with the direction of interest rates) have started rising again. Take the so-called 'benchmark' 10-year bond. Its yield hit a record low of 5.82 per cent on January 15, and has since risen to 6.69 per cent. Demand for such bonds has obviously flagged. Gilt-based mutual funds, of course, have been hit. But the other worries have to do with the large bond portfolios of banks. Since the start of 2001-02, most commercial banks in India have been making big money on the extra bonds in their possession (some quantity has to be held as a mandatory prudential measure). Now that the prices are falling, the actual asset value is suffering-- even if the losses aren't likely to be 'booked'. One school of thought is that the current phase is merely a 'war blip', and that once life is back to normal, the earlier trend of falling yields will resume. Sadly, this view is somewhat simplistic, because yield trends depend on several other factors as well. When interest rates in general start declining, investors buy previously-issued bonds that bear relatively high 'coupon' rates of interest (say 9.5 per cent per annum). And interest rates often depend on how much money there is to go around. When the yields were falling earlier in the year, the market was operating on expectations that India's central bank, the RBI, would cut the short-term 'repo rate'. Cheap money was the order of the market. The liquidity situation, after all, was such--further swamped, as it were, by the RBI's persistent dollar purchases to cap the rupee's rise (an over-strong rupee could hurt exports), in the face of robust forex inflows. The bigger influence, perhaps, was the RBI's 'soft monetary policy' (which means lower rates). But then, yields cannot keep falling forever. By January 15, yields had fallen nearly 4.5 percentage points over two years--a precipitous fall by any yardstick. Also, there's inflation to consider. Falling yields assumes benign (if not non-existent) inflation in the future. Data released over the past few weeks suggests that Indian inflation, while in no danger of breaking out, is beginning to firm up again - after a long phase of lying low - fuelled largely by a rise in global crude oil prices and demand for manufactured goods. In any case, many analysts had supposed that the low inflation was a reflection mainly of the weak state of the economy. After all, a fiscal deficit of nearly 10 per cent (of GDP) can plausibly be sustained without any inflationary pressure (and extremely low interest rates) only if growth is sluggish. The point is: any pick-up in economic activity could spark inflation--and send bond prices crashing. Some bond-laden banks may be tempted to make speculative moves now. But several will probably opt instead to hold their bonds to maturity (in which case, the secondary market price is irrelevant). For now, Indian bond traders are watching the RBI closely. Will it switch to a 'neutral monetary policy' over the next few months? That will become clear only after the latest Budget, which will declare the fiscal policy of the Union government.
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