The spread between the 10-year government security (G-Sec) and the repo rate has almost halved since the paper was first issued in early February. This is due to spurt in demand for G-Secs and thaw in retail inflation.

The spread (difference in yields) between the benchmark 10-year G-Sec and the repo rate has shrunk to 51 basis points (bps) as on May 25 from 101 basis points on February 6, when this paper was first issued.

Experts say the current spread is the lowest level since 2017.

Madhavi Arora, Lead Economist, Emkay Global Financial Services, attributed the contraction in spread to high demand for G-Secs, especially the benchmark 10-year paper, which pushed the yields down.

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“There is very high demand for G-Secs…There are no fundamental factors to it as such at this point. The rally in G-Secs has outrun even the US bond yields. G-Secs have rallied way too much.

“There has been some demand for G-secs from banks, insurance companies and other categories of investors and this is moving the yields much lower. There is some technical demand that has emerged,” she said.

Yields softened

Marzban Irani, CIO-Fixed Income, LIC Mutual Fund, said debt schemes of mutual funds invested in G-Secs in a big way in March as they received robust inflows from corporates. This softened the G-sec yields quiet a bit.

Irani observed that corporates wanted to take benefit of the old tax regime that allowed indexation benefits for long-term capital gains from debt mutual funds. This favourable tax benefit has been scrapped from April 1, 2023.

While yield of the 10-year paper has declined, the repo rate has been static at 6.50 per cent after the last hike of 25 bps on February 8, resulting on contraction in spread, he added.

Slim chance

Pankaj Pathak, Fund Mnager - Fixed Income, Quantum Mutual Fund, noted that typically, the spread between long-term bond yields over the repo rate narrows closer to a start of rate cutting cycle.

“At this stage, the probability of rate cut in 2023 looks very slim given the CPI inflation is still far from the RBI’s 4 per cent goal. Thus, the valuation on the 10-year government bond trading below 7 per cent looks stretched,” he said.

Demand-supply dynamics

The demand supply dynamics also look unfavorable going forward.

“In the last two months, the demand-supply balance in the bond market was supported by – (1) frontloading of demand from Mutual funds and Insurance companies, (2) likely buying (based on media reports) from Russian exporters and demand from HDFC and HDFC bank merger, and (3) lower supply of State Government bonds than the indicative calendar.

“We expect these one-off demands to fade away over the coming months. Overall, in the fiscal year 2023-24, we expect a net shortfall in natural demand for central and state government bonds of around ₹2.6 lakh crore.

“Thus, there would be a need for the RBI to buy bonds in the later half of the year, absence of which could push bond yields higher again,” Pathak said.

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