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Indian bond market had a dream run in the last two and a half months. The 10-year Indian government bond (G-sec) yield fell by 50 basis points from 7.46% on February 28, 2023 to around 6.98% at the time of writing this report on May 18, 2023. The 10- year government bond yield is now below the levels prevailing at the start of the rate hiking cycle in May last year.

Chart – I: Long term bond yields have fallen below the first-rate hike levels

Past Performance may or may not sustain in the future.

There have been series of favorable developments since March that led to sharp turn in investor sentiment in the bond market.

RBI’s surprise pause on rate hikes, not just moved the market expectation to an extended pause, but also led to speculation of rate cuts by the year end. The recent drop in CPI inflation below 5%, added more fuel to it.

The US monetary policy cycle is also expected to reverse as priced in the US treasury curve. Even after the partial reversal, the US treasury futures curve is still pricing for more than 50 basis points rate cut by the federal reserve in the current year.

The bond market also witnessed a sudden spurt in demand from local investors. Part of it can be attributed to the sharp jump in inflows in debt mutual funds and insurance companies during the last two weeks of March when investors rushed to invest before the favorable tax deadline on 31 st March 2023. To recall, the government has removed the favorable tax treatment on debt mutual funds compared to bank fixed deposits and capped the insurance premium to Rs. 5 lakh per annum for tax exemption.

Will the trend continue?

After the sharp drop in yields, the valuation cushion in the long-term bonds is exhausted. The spread between the 10-year government bond and the repo rate has shrunk to 48 basis points from 94 basis points in February 2023. This is lowest level observed since 2017. Even during the 2019-2020 period when the repo rate was cut by 250 basis points, this spread was materially higher than current levels.

Typically, the spread between long term bond yields over the Repo rate narrows closer to a start of rate cutting cycle. At this stage, the probability of rate cut in 2023 looks very slim given the CPI inflation is still far from the RBI’s 4% goal. Thus, the valuation on the 10-year government bond trading below 7% looks stretched.

Furthermore, the demand supply dynamics looks unfavorable going forward. In the last two months, the demand-supply balance in the bond market was supported by – (1) frontloading of demand from Mutual funds and Insurance companies, (2) likely buying (based on media reports) from Russian exporters and demand from HDFC and HDFC bank merger, and (3) lower supply of State Government bonds than the indicative calendar.

We expect these one-off demands to fade away over the coming months. Overall, in the fiscal year 2023-24, we expect a net shortfall in natural demand for central and state government bonds of around Rs. 2.6 trillion. Thus, there would be a need for the RBI to buy bonds in the later half of the year, absence of which could push bond yields higher again.

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