India short bonds may underperform on rate hikes, cash squeeze

India’s shorter bonds will likely resume their underperformance against longer peers as tightening liquidity and monetary conditions rein in appetite for the rate-sensitive notes.

The Reserve Bank of India may raise interest rates by as much as 75 basis points in the coming months, adding to a 25-basis-point hike on Oct. 7, according to IDFC First Bank Ltd. and Deutsche Bank AG. The central bank is also absorbing liquidity from the banking system, with excess cash dwindling from a record high in early September. The impact is visible in the bond market where the gap between the shorter and longer-end yields shrunk to the lowest since May earlier this month, before widening again as crude prices slid.

“Short bonds are more sensitive to immediate interest-rate expectations and liquidity conditions,” said VRC Reddy, head of treasury at Karur Vysya Bank. “I expect such notes to underperform as more rate hikes are still on the cards given how the inflation trajectory is poised.”


Higher short-term yields can raise funding costs for banks and companies, tighten credit conditions and eventually weigh on consumption, investment and economic growth, which has so far showed resilience despite the Middle East war. The government canceled a sale of 182-day treasury bills last week as traders likely demanded higher yields.

Cash conditions are expected to remain modest going forward and a drain in liquidity is likely to impinge on deposits where a wedge with credit growth may again open up, according to an Axis Bank research note.

The spread between the five- and 10-year yield has narrowed to about 32 basis points from 37 basis points at end-August, according to data compiled by Bloomberg. IDFC First Bank and Quantum Asset Management Co. are among those expecting the curve to flatten more. Yields on treasury bills, which mature within a year, have also shot up to trade around the highest level in more than a year.

“A temporary flattening to zero, or even a mild inversion, cannot be ruled out if the RBI withdraws liquidity more aggressively and the market prices a higher terminal rate,” said Sneha Pandey, fixed-income fund manager at Quantum.

Yields rose more sharply at the short end after the RBI began withdrawing cash that flooded the banking system, as lenders swapped dollars raised through a diaspora deposit program for rupees. The central bank has since drained liquidity through sell-buy currency swaps and 1.25 trillion rupees ($13.3 billion) of bond sales via open market operations, shrinking the banking cash surplus to 2.3 trillion rupees as of Nov. 5 from 11 trillion rupees in early September.

To be sure, the five-year yield fell 33 basis points last week, outstripping a 22 basis points drop in the 10-year debt as crude prices plunged, easing inflationary pressures for the oil-importing nation. That’s lowering the bets of a jumbo half-percentage-point rate hike in December.

Still, the outlook is uncertain. India’s retail inflation data due Thursday will likely show price growth hitting the central bank’s 6% upper tolerance level for the first time in two years, according to a Bloomberg survey of economists. That makes a rate hike imminent in the next policy.

“Indian bonds have to navigate an intensifying domestic inflation scenario for the foreseeable future alongside higher global neutral rate settings, the latter reflecting the ongoing competition for global capital,” said Suyash Choudhary, chief investment officer at Bandhan AMC Ltd. “This should keep the yield curve relatively flat with floor levels on yields likely having moved up.”