Steepening yield curve will benefit investors

The inverted nature of yields curves across government bonds, corporate bonds and interest rates swaps are set to see a change with yield curves steepening across the three segments of the fixed-income market.

Steepening yield curves are good for investments in short-term fixed-income instruments that are marked to market. Steepening yield curves also have the ability to give a push to a flagging economy. Investors should invest in short-term, fixed income funds that generate returns when prices of short term fixed income securities rise. Investors should also be invested in equities on the back of yield curve steepening expectations.

Why will the yield curves steepen?
Because of two factors: a) Repo rate cuts by the Reserve Bank of India; b) Easing systemic liquidity.

Steepening yield curves mean one-year yields will be below the five-year and ten-year yields, while five-year yields will be below ten-year yields.

Table 1 shows that one-year yields are above five and ten year yields and this should correct going forward.

Five-year yields are above or at ten year yield levels and this should also correct going forward. Hence, one- and five-year yields will fall sharply leading to a steepening of the yield curves. RBI is widely expected to cut repo rates in its annual policy for 2012-13 scheduled for April 17, 2012.

Slowing GDP and a sharp fall in monetary aggregates will prompt the RBI to cut repo rates. GDP growth for fiscal 2011-12 has come off to 6.9% from growth of 8.4% seen in fiscal 2010-11.

Monetary aggregates of deposit, credit and broad money supply (M3) growth for fiscal 2011-12 have also come off by 2.2%, 5.3% and 2.9%, respectively, from growth rates seen in 2010-11.

RBI will also look to ease liquidity conditions in the system. Liquidity conditions have been in deficit for almost two years now with banks borrowing from RBI on a daily basis to meet their fund requirements.

Tight liquidity conditions have brought down the ability of banks to lend as seen in the fall in credit growth and slower credit growth in turn has led to slow deposit growth. RBI will ease liquidity by reducing repo rates to encourage banks to pass on lower costs to the borrowers, which in turn will lead to more demand for credit.

Rate cuts coupled with easing system liquidity will bring down yields at the short end of the curve as the spread between short-term borrowing costs and short-term yields widens, making it more attractive for banks to borrow and invest in short-dated bonds.

Yield curves will also steepen on the back of the fact that only 32% of the total government borrowing of Rs370,000 crore for the first half of fiscal 2012-13 will be in five years and less maturity securities.

The lower supply in shorter-dated securities will push up demand for bonds at the short end of the curve leading to yields falling for short dated government bonds. The higher supply at the longer end of the curve will lead to yields being pressured given that demand may just match supply.

Why did the yield curves invert?
Tight liquidity conditions coupled with policy rate hikes due to inflation have led to yields on short maturity bonds moving higher than longer maturity bonds. RBI has hiked the benchmark policy rate, the repo rate, to 8.5% from lows of 4.75% seen in fiscal 2009-10. Inflation has consistently trended at over 9% levels in 2010 and 2011, prompting the RBI to maintain a tight monetary policy leading to yield curve inversion on the back of rising short-term borrowing costs.

Higher short-term borrowing costs lead to lower demand for short maturity bonds and yields on bonds at the short end of the curve rise.

How will a steepening yield curve benefit investors?
Yield curves steepening due to fall in yields on short maturity bonds will push up the prices of the bonds. (Price and yields are inversely correlated). Investors investing directly in short dated bonds or indirectly through short term fixed income schemes of mutual funds will benefit from capital gains as bond prices rise.

Equity investors too benefit from yields on short dated bonds falling as it will bring down cost of funds in the system leading to higher appetite for borrowing and investing. Banks cost of funds will fall and this will result in falling lending costs as well. Lower interest rates across the system will benefit the economy.