According to the RBI website, 91-day treasury bills were quoting at 8.52 percent while the 364-day bill was trading at 8.89 percent on mid-June 2014. So why are yields still high? Where are the yields headed? What should you, as a bond investor, do? Here are the answers.

Bonding well with the right bonds

in Finance

What should bond investors do while buying bond at the current high yields? Here’s the lowdown to the right strategy

As we go to push the state of affairs remains far from rosy in the bond market. Yields are high while price are falling. The yield on the 10-year benchmark government security (G-sec) is 8.64 percent, down 35-basis points (bps) from the 9 percent, mark it breached in November 2013. The situation was very bad last year as there were fears about the US quantitative easing, which led to foreign institutional investors (FIIs)selling off in the Indian debt market. This led to a fall in the Indian rupee, and the Reserve Bank of Indiahad to take liquidity tightening measures. Naturally, yields touched peaks. Things are better this year with receding fears of the impact of the phased withdrawal of quantitative easing and better liquidity in the market. Put into this the detail that inflation has eased a bit this year. But yields are still sitting pretty. Even short-term yields seem high.

According to the RBI website, 91-day treasury bills were quoting at 8.52 percent while the 364-day bill was trading at 8.89 percent on mid-June 2014. So why are yields still high? Where are the yields headed? What should you, as a bond investor, do? Here are the answers.

There are two key reasons why yields are still high. First is the inflation numbers. Inflation, both wholesale price index and consumer price index (WPI/CPI), have come down but stayed above comfort level. Inflation figures for May 2014, which came out in mid-June, showed that WPI inflation was 9.5 percent, up from 8.64 percent in April. This was despite the fact that CPI was recorded at a three-month low of 8.2 percent. This scenario of higher WPI might continue in the near term. Says Aditi Nayar, senior economist, ICRA, “Persistence of the go up in prices of crude oil and the Indian rupee’s weakness in the continuing month could nourish through to advanced core inflation going ahead.” The possibility of poor monsoons just makes things worse. The Indian weather department has predicted that the rainfall between June and September this year would be lower than average. This is likely to affect summer crops such as rice, corn and cotton, sending price upwards. So, food inflation might remain high if food supply is not managed properly, leading to nil possibility of cut in interest rates. Says Avnish Jain, head fixed income, Canara Robeco Mutual Fund, “RBI may remain on hold for some time as it closely watches the trajectory of inflation over the next few months.” All this would keep long-term yield on the higher side in the near future. Says Jain, “Expect the 10-year yield to remain at 8.4-8.80 per cent with a downward bias, till the budget is announced.”

The second season for high yields is that RBI is not buying bonds from the market like it did earlier trough open market operations (OMO). Says Rakesh Goyal, senior vice president, Bonanza Portfolio, “RBI did not announce any OMO even though they were widely expected by the market.  This has made the yields to harden.” RBI usually announces OMO worth over Rs.1,00,000 crore every year. In 212-13, it did not even announce half of that amount. Instead, to tackle the rupees, RBI has been selling bonds through OMO. During the first week June 2014, RBI sold over Rs.2500 crores worth of bonds. There are doubts that this strength lead to lower bond prices. Also banks are cautious when buying bonds from the market as they had suffered huge losses on their bond portfolio due to the supply is huge. Therefore, yields are high due to the demand-supply mismatch.

The question that arises is – what would happen to bond yields in the medium term? They are expected to moderate and then fall in the next one year. Rahul Goswami says, fixed income CIO, ICICI Prudential AMC, “Bond yields are probable to stay range-bound, with a downward prejudice in the medium term. Fiscal consolidation, continued step up in current account and a moderating CPI could provide RBI the space for monetary easing and lowering interest rates.” Inflation is expected to moderate by next year. Indranil Pan says, Kotak Mahindra Bank’s chief economist, , “We see an almost nil probability of any rate increases by the RBI through this fiscal, and expect the next change in the key interest rate to be on the lower side.” So, long-term yield would start moderating as inflation fears go down. Though short-term yields have already started moderating, further downside cannot be ruled out. Says Jain, “Short-term rates may continue to drift downwards, as liquidity remain easy.” Adds Dhawal Dalal, head-fixed income, DSP Blackrock Investment Managers, “Technically, short-term yields would fall much faster than long-term yields, making the yield curve steeper.”

This being the scenario, what are the bond investments you should look at? Given the stability gained in bond yields, it is best to increase the duration of your FI portfolio. Says Dalal, “Those who have been in the shorter end of the yield curve should start taking stock of their portfolio and should look at increasing its average maturity.” New bond investors can also procure bonds from the secondary market available at attractive yields or discounted face value. These include both government and corporate bonds. As long as long-term yields remain high in the near term, it is prudent to lock into them before they start falling. Says Dalal, “Once yields start falling in a couple of years, one could make good profits from the price appreciation in bonds.”