RBI rate cut only good for short-duration bonds as hopes of big cuts fade

India's short-duration bonds are set to outperform as traders temper their enthusiasm on the size of future rate cuts. 

Yields on shorter notes dropped for a second day after the Reserve Bank of India delivered a larger-than-expected cut Wednesday, while those on the longer-maturity bonds held gains as Governor Shaktikanta Das said further easing would depend on incoming economic data.

"Shorter bonds are finding favour because it gets the dual benefit of lowering of interest rates and the comfort of liquidity," said Lakshmi Iyer, chief investment officer for debt at Kotak Mahindra Asset Management Co in Mumbai. "If you look at the yield curve, we find shorter-end to be the most attractive."

The 10-year paper "is going to lose its charm," said Naveen Singh, head of fixed-income trading at ICICI Securities Primary Dealership Ltd. By delivering a larger-than-expected cut, the RBI used up the space available to it, he said.

The yield on 7.32% notes maturing in 2024 dropped four basis points, extending Wednesday's seven-basis point drop, while that on 2026 paper declined 13 points in two days. Benchmark 10-year bonds ticked higher, adding to yesterday's advance.

The RBI reduced its main rate by an unconventional 35 basis points to 5.4%, the lowest since 2010. The move surprised most of the 40 economists surveyed by Bloomberg who had predicted a quarter-point cut. 

Das told reporters in a post-policy briefing that a 50 basis-point drop would have been "excessive." Traders interpreted this to mean that there's no space for significant reduction hereafter. Bonds rallied in July, pushing down yields 51 basis points, on bets the RBI will add to three rate cuts this year and guide for further easing.

"There could be an additional 25 basis point cut but that would not be enough to sustain this bond market rally," said Pankaj Pathak, fixed income fund manager at Quantum Asset Management in Mumbai. "The best of the rally is now behind us."