Short-term bonds likely to outperform long-term peers in near term

Liquidity is expected to improve significantly after the RBI's record surplus transfer to the government

Short-term government bonds are expected to outperform long-term bonds in the near term on the back of improvement in liquidity in the banking system, according to market participants.

The yield spread between five-year government bond and the benchmark 10-year government bond currently stands at 3 basis points (bps). And, this is expected to widen to around 10 bps by June-end, they said.

“Short-term bonds of tenure up to 3-5 years will outperform the 10-year ones. What we call bull steepening will be at play,” said Vikas Goel, managing director (MD) and chief executive officer (CEO), PNB Gilts.

“Ten-year yield may fall 3-4 bps. It has already fallen 4 bps, but short-term will fall another 10 bps by June end,” he added.

The benchmark 10-year government bond yield settled at 7 per cent on Friday. The five-year bond yield stood at 7.03 per cent.

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Traders were increasingly stocking up on long-term bonds, especially those with 10-year and 14-year maturities. They were doing it for the past one month on expectations of capital appreciation following inclusion of domestic bonds in JP Morgan bond indices.

The short-term bonds were less in demand due to liquidity deficit within the system and uncertainty around rate cuts.

“The yield on the five-year bond is higher than the 10-year bond, which indicates an inversion of the yield curve. As the liquidity improves, the money market rates may fall to 6.5 per cent. This will lead to some yield softening in short-term bonds,” said a dealer at a state-owned bank.

The liquidity is expected to improve significantly after the Reserve Bank of India's (RBI’s) record surplus transfer to the central government. The RBI approved a dividend of Rs 2.11 trillion for the Centre for financial year 2023-24, marking an increase of around 141 per cent from financial year 2022-23.

Liquidity in the banking system showed a deficit of Rs 2.3 trillion on Thursday, according to the latest data by the central bank.

The RBI also revised the calendar for treasury bills, which is further expected to aid liquidity. The updated schedule from May 22 to June 26 includes a reduction of Rs 60,000 crore in the issuance of treasury bills.