Bond supply may outweigh demand, push yields higher

Mumbai: Bond yields are likely to face upward pressure in the second half of this fiscal as the government borrowing calendar coincides with the Reserve Bank of India's likely sale of another ₹1 lakh crore of government securities through open market operations (OMO) sales, IDFC First Bank said.

The rise in net supply comes at a time when US yields remain elevated, domestic inflationary pressures have picked up and the RBI is expected to begin a shallow rate-hiking cycle from October.

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Against this backdrop, the bank expects demand for government securities to fall short of supply. "Demand for government securities is expected to undershoot supply by a wide margin given higher supply and tighter financial conditions," Gaura Sengupta, chief economist at IDFC First Bank said in a note on Tuesday. "And because credit growth remains strong, only replacement demand is expected from banks."

The 10-year government bond yield has risen steadily over the past month, closing at 7.16% on Tuesday.

Sengupta expects yields to rise further towards 7.25%, while traders see the 7.25% level as a key support, where stronger buying interest is likely to emerge and cap further upside in yields.

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"We have moved to a clearly bearish duration stance. The combination of multiple factors like strong domestic growth, inflation risks, persistent surplus liquidity and the RBI's shift to OMO sales argues against carrying a large structural duration position," said Prashant Pimple, chief investment officer - fixed income at Baroda BNP Mutual Fund.

"We would rather earn carry while retaining the ability to add duration when the market offers better entry points," he said. The trajectory of bond yields will also depend heavily on oil prices. While traders see 7.25% as a level where buying could re-emerge, that support may not hold if crude remains elevated around $110 a barrel.