Gilt yields touch 3-year high

Rate hike pause seen postponed; govt’s borrowing cost rises as bond prices tumble.

Expectations of a pause in policy rate rises appear to be fading, with the yield on the benchmark government security hitting a three-year high on concerns of a supply glut. Yields on 10-year benchmark government bonds closed at 8.54 per cent on Monday, highest closing level since 29 September, 2008.

Bond prices fell by 59 paise on Monday, after the government announced it would increase its borrowing by Rs 53,000 crore during the second half of the current financial year. The government is selling bonds worth Rs 15,000 crore this week.

The hardening of yields has postponed the pause in rate rises that the market was expecting. The Reserve Bank of India (RBI) has raised key policy rates 12 times since March 2010 to tackle inflation, which has hovered around 10 per cent for nearly one and half years.

"The increase in bonds yields might postpone the market sentiment that a pause or a reversal in the interest rate cycle is around the corner. Market participants have started expecting that interest rates have peaked. But now, there is uncertainty that because of fiscal slippage, market-linked interest rates may not fall," said Chakraborty. RBI would next meet on 25 October to review the monetary policy stance.

Yields on the benchmark bond hardened by 20 basis points since the enhanced borrowing plan was announced on Thursday. The government bond market remained closes on Friday, Saturday and Sunday.

T S Srinivasan, general manager (treasury), Indian Overseas Bank, said this sharp rise in yield on government bonds may not impact bank lending and borrowing rates. However, it would keep the rate cycle at a peak for slightly longer period than before.

"Yields on 10-year papers were pushed higher, as the old paper (7.80 per cent, 2021) is being sold on expectation of issuances of new 10-year bonds. The yield may remain in range of 8.45-8.50 per cent," Srinivasan said. So far, the government has issued Rs 62,000 crore worth of the current 10-year benchmark bond.

According to a report by Nomura Securities, there could be new bond issuance in the 10-14 year bucket in November 2011, when the government is scheduled to borrow around Rs 50,000 crore. The rising yields would make the average cost of borrowing dearer for the government, analysts said. The cost has already gone up by 70 basis points on a year-on-year basis.

"The average borrowing cost of the government in the first half of the current financial year has already gone up by 70 basis points to 8.4 per cent, compared with 7.7 per cent during the same period of the previous year. With additional borrowing, the cost can rise further," said Samiran Chakraborty, regional head (research), Standard Chartered Bank.

Quick estimates suggest a 10-basis point rate hardening would exert additional pressure on government borrowing cost by Rs 220 crore. If a new security is introduced in the market now, the coupon of that security would be fixed at a higher rate and the government has to pay the rate for the entire duration of the paper. According to the borrowing calendar, there are more issuances in the 10-14 year tenor in the second half of the current financial year.

The higher borrowing plan would also have an impact on the overnight indexed swaps, as market participants try to hedge their long bond exposure by paying five0-year OIS, said Vivek Rajpal, interest rates strategist at Nomura.

Banks' profitability would also come under pressure, as rising yields would force banks to make provisions on marked-to-market losses on their government bond portfolio. Thursday's 10-basis point rise in yields has already made some banks estimate higher provisioning on investment for the second quarter.