Amid liquidity crunch, shorter-tenure govt bonds lag 'longer' peers

Short-term government bonds fell behind longer-dated securities in demand this month so far due to a liquidity crunch in the banking system and expectations of a delay in a rate cut, said market participants.

Investors have favoured longer-tenure government bonds, or g-secs, with insurance companies and pension funds leading the charge by stocking up on those with maturities of 30 years and more.

Preference for longer-term securities was strengthened by the conclusion of the borrowing programme on Friday, which compelled institutional investors to fulfil their requirements in the secondary market.

While banks tend to favour shorter tenures due to their liability profiles, investors such as pension funds and insurance companies prefer longer-term bonds to match their long-term obligations.

Consequently, the middle of the curve, particularly the range of 10-14 years, becomes primarily focused on trading rather than long-term investment.

The yield on the 40-year government bond fell by 12 basis points in February as of Friday (the money markets were closed on Monday). Bonds with a maturity of up to five years were out of favour, with the yield on five-year and three-year government bonds rising by 1 and 3 basis points, respectively, in the same period.

The yield on the benchmark 10-year government bond, too, fell by 5 basis points in February.

Liquidity in the banking system has remained in deficit since December 5, 2023. It stood at Rs 2.10 trillion on Thursday, according to the data from the Reserve Bank of India (RBI).

“Short-term bonds are not in favour because of deficit liquidity and rate-cut expectations being pushed back,” said V R C Reddy, head of treasury, Karur Vysya Bank.

“Long-end is in favour because the (Union) Budget was positive, and the market knows rate cuts will be delayed, but it is certain (there will be cuts). So, the market is taking positions on the long end in the hope that the next step will be a rate cut,” he added.

Meanwhile, the bond market exhibits a nearly flat yield curve with a slight inversion. The curve is expected to correct itself as liquidity stabilises and money-market rates align with the repo rate. Shorter-term bonds, with maturities of one to two years, are expected to regain prominence with the curve becoming slightly steep in the near term, said market participants.

“In terms of outperformance in yield terms, the front end is now ripe. As the call rate settles near the repo rate and it continues for two-three weeks, we will see the 364-day treasury bill coming down to maybe 7 per cent from 7.15 per cent now,” said Vikas Goel, managing director and chief executive officer at PNB Gilts.

“There will be a slight steepening of the curve, which is required. It has started already but then again due to fixings (fine-tuning of liquidity), it went back-up, which spoiled the party,” he added.

Earlier in February, when the liquidity deficit eased to Rs 1 trillion, overnight money-market rates had dipped below the repo rate. In response, the central bank initiated variable rate reverse repo auctions to realign the rates with the repo rate.

However, the call rates surged close to the marginal standing facility rate in the previous week.