Yield spread signals more surge in India bond rates, say analysts

Investors should brace for a further rise in the yield on the benchmark 10-year Government of India (GoI) bond as the spread remains lower than the historical average. The yield on the 10-year GoI bond is currently 491 basis points higher than the yield on the 10-year US Treasury bond. It is also 40 basis points less than the average yield spread of 531 basis points since January 2010. 

The Indian bond market on Friday closed at a yield of 6.753 per cent, marginally up from Thursday's 6.746 per cent. The yield on the 10-year US government bond was around 1.84 per cent on Friday, against 1.81 per cent a day ago.

According to analysts, this gap creates space for a further increase in bond yield in India. "The bias should be on the higher side, given the increased volatility in the bond and the currency markets and a higher risk premium for emerging markets like India," says Dhananjay Sinha, MD and chief strategist JM Finance Institutional Equity. He expects the 10-year bond yield in India to rise to around 7.5 per cent by the end of the current calendar year from around 6.75 per cent currently and the post-Covid-19 low of 5.8 per cent in July 2020.

Higher yield on 10-year GoI bonds would push interest rates and that will impact asset prices, including equities. A higher interest rate on a risk-free asset, such as Treasury bonds, translates into a lower price for risk assets like equity, real estate, and commodities.

This is not unreasonable given the historical trend in the yield spread between India's and US' 10-year Treasury bonds. The spread widened to around 550 basis points in March and April 2020 and then it contracted to 440 basis points as the US Federal Reserve and the Reserve Bank of India flooded the markets with record liquidity. 

In the past, the yield spread had shown the tendency to widen in the event of a monetary tightening by the American central bank.

For example, the yield spread widened from 400 basis points in January 2010 to a high of 700 basis points by May 2012 as the Federal Reserve tightened its monetary policy, leading to a small decline in its balance sheet during the period.  The Fed shrunk its balance sheet from the then high of $2.9 trillion in July 2011 to around $2.8 trillion by the end of October 2012. 

The US central bank plans to shrink its balance sheet once again, starting March this year. This will reduce the flow of dollars to emerging markets, leading to higher bond yields across the globe.
 

In the past 12 months, bond yields in India are up around 52 basis points against a 44-basis points rise in yields in the US during the period. Bond yields in India are also likely to be supported by the country's record high public debt and the growing current account deficit. 

"India requires higher interest rates to attract foreign capital to fund our growing trade and current account deficit," says Madan Sabnavis, chief economist at Bank of Baroda. He expects the yield on 10-year government bonds to reach 7 per cent in the next few months. 

In the domestic market, a record high public debt-to-GDP ratio of 90 per cent has resulted in a sharp rise in new bond issuances by the central and state governments, prompting investors to demand higher yields or interest rates.