Shorter-end bonds a rare bright spot in tough markets

By Swati Bhat and Neha Dasgupta

MUMBAI (Reuters) - Shorter-dated government bonds remain the one lucrative opportunity in debt markets after a tough March burnt investors who bet on a rally that failed to take off.

A lacklustre 2013/14 union budget and the Reserve Bank of India turning gun-shy on interest rates have erased most of the strong debt gains this year, denting hopes that 2013 would be stellar for government bonds.

As investors re-adjust their expectations, bonds with maturities of four years or less are showing appeal, as the government's gross sales of $107 billion of bonds will focus on longer tenors.

Simultaneously, India also plans to buy back 500 billion rupees of debt with shorter maturities, which would directly benefit investors if the country opts to buy those securities from them as opposed to from the central bank.

"We are likely to see a pivotal steepening of the curve as it would be caused by both short-end coming down and long-end going higher," said Nagaraj Kulkarni, a senior rates strategist for South Asia at Standard Chartered Bank in Singapore.

Kulkarni expects the spread between 1-year treasury bills and 10-year benchmark bond yields to touch 40 basis points from 17 bps at current levels.

Expectations for an outperformance at the short-end are being driven by India's plan to borrow 3.49 trillion rupees in the April-September period by primarily targeting debt maturities of 10-14 years.

The amount sold in the six-month period represents 60 percent of the total gross 5.79 trillion rupees in borrowing targeted for the full fiscal year.

The heavy supply should pressure 10-year bonds at a time when yields have already risen 15 bps after India unveiled a fiscal budget for the year starting in April that increased spending by targeting higher revenue.

The skepticism about the budget plan was then compounded after the RBI stuck to a cautious tone on future monetary policy easing despite cutting interest rates for a second time this year on March 19.

By contrast, shorter-end bonds could rally from the lack of debt sales in these maturities. Nomura expects the 8.07 percent July 2017 bond to hit 7.60 percent by the end of April from 7.88 percent at current levels.

Simultaneously India plans to buy back 500 billion rupees in debt and exchange them with longer debt. These purchases are expected to focus on bonds maturing between 2015 and 2018 given the government faces the most maturing debt in those years.

Graphic on redemptions: http://link.reuters.com/gew76t

A key issue will be whether the government opts to buy back and exchange the debt from bond investors directly as opposed to purchasing the debt from RBI.

In meetings with RBI officials, traders and primary brokers have suggested splitting the two operations: buying short-dated debt from markets, but then directing insurers and pension funds to buy longer-dated debt directly from the central bank, according to four market participants who attended.

That split would not only support shorter-dated bonds, but would reduce pricing pressures on longer-dated bonds given insurers and pension funds are steady buyers of these longer maturities due to their balance sheet requirements.

"The market is concerned that there will be incremental supply of debt at the longer-end if switch happens in the market," said a primariy dealer who attended the meeting.

"So it would be phenomenally positive if the switch happens with the RBI." (Editing by Rafael Nam and Sanjeev Miglani)