Yield curve not based on real market conditions: Economic Times 6th July 2011

The government debt market trades almost as much as the cash segment on NSE at around Rs 15,000 crore a day. The size of the market is large with outstanding central government paper of around Rs 25 lakh crore, with net annual addition of around Rs 3.5 lakh crore of paper. Yet, there are some interesting statistics on the topography of trade that takes place in this market. More than 80% takes place in paper with a residual maturity of 10 years and above, despite the fact that around 38% of fresh paper being issued has over 10 years maturity, with an equal share for papers with 5-10 years maturity. What does this indicate? The market is still narrow in terms of trade taking place. A curious factor is that the difference in yields on 1 year and 10 year paper is around 15-20 bps.

Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.

Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.

First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .

Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.

Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .

At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.