The 10-over-30 segment of the government bond yield curve has compressed such, it has to shift down for the levels to sustain.
The spread between the benchmark ten-year 8.15% 2022 bond and the 8.30% 2042 bond is at 14 basis points (bps).
The spread at the time of the issuance on December 28, 2012 was 19 bps and one month back was 23 bps.
The market has chosen to aggressively bring down the yields on the 30-year bond in the belief that interest rates will fall going forward and long bonds give more bang for the buck in a falling interest rate scenario.
The 14 bps difference in spreads between the 10- and 30-year bond is extremely low given current inflation expectations.
Inflation as measured by the wholesale price index may come in at 7.40% for December and is expected to trend under 7% in March. However given the increase in fuel prices by the government, inflation could rise as the next fiscal begins.
The 10 over 30 spread was as high as 50 bps a couple of years back as inflation was trending at levels of 9% and above. The sharp fall in the yield of the thirty-year bond indicates that the markets are not worried about inflation and, in fact, expect it to come off going forward.
The low spread between the 8.15% 2022 and other widely traded bonds in the 15 to 30 year segment of the yield curve also indicates that the ten-year bond is being given an illiquidity discount.
The spread between the 8.15% 2022 and the 8.33% 2026, and the 8.97% 2030 is at 7 bps and 13 bps, respectively.
The 8.15% 2022 bond has a total outstanding amount of Rs 64,000 crore and at best another Rs 16,000 crore issued will be issued. The bond market is giving the 8.15% 2022 bond an illiquidity discount and is treating it as an off-the-run.
The issuance of a new ten-year bond will see cut-off 15 bps lower than the current levels of 7.87% traded on the 8.15% 2022. That would mean the ten-year bond should actually be trading at levels of around 7.72% and yield curve spreads should actually be calculated based on where a new ten-year bond should trade.
The 8.30% 2042 is at 8.01% and spreads with a new ten-year bond will be more reasonable at levels of around 25 bps assuming the yield falls to 7.95% when a new bond is issued.
The fact that a fresh issuance will shift the yield curve down indicates that the bond market is highly positive on interest rates coming off.
It is comfortable with very low spreads in 10 over 30 and will not worry even if the spread rises as the yield curve shifts down. Participants will worry only when absolute levels of yield rise on the 30-year bond and that is not on the cards in the current environment.
