New 10-year bond pricing flags concern of inflation, say dealers

The latest bond coupon at 7.26 per cent is higher than expected

The conservative pricing of the new 10-year benchmark government security -- auctioned for the first time on Friday -- reflects the bond market’s concerns about elevated inflation, further policy tightening, and large debt supply pressure, dealers said. The government auctioned a new 10-year bond maturing in 2032 in the primary market, the coupon for which was set at 7.26 per cent.

The 6.54 per cent 2032 paper, the previous 10-year benchmark paper, also closed at a 7.26 per cent yield on Friday, two basis points higher than Thursday's close. Bond prices and yields move inversely.

The coupon on the new 10-year bond -- or the rate of interest that the government pays to bondholders -- was higher than many traders had expected, reflecting a pessimistic view of the market.

Higher yields demanded by investors at primary auctions of government bonds indicate market expectations of a higher cost of funds ahead due to increases in benchmark policy rates by the Reserve Bank of India. Usually, the auction of a new 10-year bond is greeted with aggressive demand as the 10-year security is the pricing benchmark for the bond yield curve.

Over the past few years, in most cases, the coupon on a new 10-year bond has been set around 10-12 basis points below that of the prevailing yield on the existing 10-year benchmark paper. In some instances, the coupon on the new 10-year paper has even been priced over 20 basis points lower than that on the existing incumbent.

But in Friday’s auction, the coupon on the new 10-year bond was set two basis points higher than the previous closing yield on the 6.54 per cent 2032 paper.

Before the auction, many traders had expected the coupon on the new paper to be set in the range of 7.34-7.24 per cent. “Maybe the market perception or market expectation before the auction was wrong. Demand was much more subdued than was earlier thought,” Naveen Singh, head of trading at ICICI Securities Primary Dealership, told Business Standard. “The auction was fairly priced because the secondary market closed at parity. It tells us that people are cautious. I don’t think anyone has a strong expectation of a sustained rally anytime in the near future.” 

Singh predicted a range of 7.20-7.40 per cent for the 10-year bond yield over the near term.

The judicious approach to pricing the new 10-year paper is understandable as India’s inflation remains well above the RBI’s target zone of 2-6 per cent, suggesting more increases in interest rates by the central bank.

“Lower input costs will be used by firms to offset the ongoing margin squeeze, thereby keeping CPI (consumer price index)-liked inflation sticky, even as WPI falls,” economists from Nomura wrote.

“Overall, we expect the headline CPI inflation to remain above 6 per cent until February 2023, even as WPI inflation moderates,” they wrote.

Retail inflation, which is the RBI’s policy anchor, was at 6.7 per cent in June. The RBI has raised the repo rate by 140 bps since May to bring inflation within the target zone.

The cautious pricing of the new 10-year benchmark bond shall have broader implications for the economy as sovereign bond yields are the benchmarks for pricing a vast variety of credit products. Corporate borrowing costs are also linked to yields on government securities.

Since 2019, some categories of bank loans, including those for micro, small and medium enterprises (MSME), and retail loans, are linked to external benchmarks. One of the benchmarks used is yields on short-term government securities.