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B. Venkatesh

THE 10-year bond closed last week at 5.60 per cent. Week-on-week, the yield curve shifted marginally downwards, as traders continued to bid up bond prices. Going forward, bonds are likely to remain biddish but may trade in a tight range.

The RBI is scheduled to hold bond auctions between August 1 and 7. The current rally suggests that the market does not expect the Central bank to increase the notified amount in the auction to drain the excess liquidity in the system. Further, with the RBI ruling out any OMOs for the present, the system will be flush with liquidity. And that is likely to keep bonds bid.

Then, the market expects inflation to decline marginally, owing to good monsoon. Should inflation decline as expected, the RBI may decide to cut the repo rate, which is at present lower than the inflation rate. The expectation of a rate cut is another reason for bonds to remain biddish.

On the flip side, the decline in yields week-on-week has led to highly concave-shaped yield curve. The long-term spread is just 58 bps, and the short-term spread is 63 bps. This reduces the convexity advantage of long-term bonds, and exposes the portfolio to high interest rate risk. Yield investors, who can take on liquidity risk, may still find some value picks on the curve. There is, for instance, about 15 bps differential between the 9 per cent 2013 bond and 9.81 per cent 2013 bond.

Finally, if the rally in state government bonds last week is anything go by, traders may bid up corporate bonds in the coming week. The good first quarter performance from companies may lead to decline in the term structure of credit spreads. In the event, there will be a positive impact on mutual funds that have investment-grade corporate bonds in their portfolio.

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