The uncertainty on extent of Open Marker Operationss and RBI’s approach toward OMOs should keep supply prone zone of the yield curve (>5-year to 14-year bonds) under pressure,forecasts Nomura

The bond market is still uncertain on the future of OMOs (bond buybacks - open market operations of RBI – Reserve Bank of India), says Nomura Financial Advisory and Securities (India) Private Limited in its First Insights research note. Along with the impact on rupee liquidity from FCNR (foreign currency non-resident) deposits, which questions the extent of the bond buyback requirement, the RBI Governor’s remark on OMOs in a post-policy conference also underlines the uncertainty: “I don’t know whether it should be long bonds or short bonds….we could debate what maturity of bonds we should use and whether we should have a significant effect in the long end and whether we should, those are all issues that are completely open for debate”. The uncertainty on extent of OMOs and RBI’s approach toward OMOs should keep supply prone zone of the yield curve (>5-year to 14-year) under pressure, forecasts Nomura.

Nomura notes that OMOs during the second half of the fiscal year have historically been heavily supportive of India’s bond markets and have kept yield curves flat, despite the issuance pressure in the belly of the curve. However, the current uncertainty on the RBI's approach toward OMOs will keep bonds with a maturity of greater than five years under pressure. As such, Nomura believes that, once market expectations of the terminal repo rate stabilise (the OIS - Overnight Indexed Swaps curve should guide us in this respect), investors can then look to accumulate bonds in shorter tenors (i.e., 3-year to 5-year). However, for bonds with tenors greater than five years, especially 7 years to 14 years (where bond supply is heaviest), the uncertainty (around OMOs) needs to be resolved before the market can stabilise there. As such, only long term investors (who are less prone to mark-to-market moves) should look to accumulate at good absolute levels (e.g., close to 9% on the 10yr benchmark).

Nomura expects that Rs1-1.2 trillion of OMOs in the second half of this fiscal year. However, the uncertainty over the RBI's approach to OMOs will likely dominate price expectations in the near term. Therefore, Nomura suggests that investors stick with the 3-year to 5-year part of the curve, and wait for clarity on the RBI's approach toward OMOs before looking at tenors beyond five years.

Before the bond market can reach a state of equilibrium, there is another source of uncertainty, according to Nomura. The market is still uncertain on the terminal repo rate. Looking at the OIS forward curves, the market is pricing in about an 8% terminal repo rate. However, given the uncertainty and ‘data dependent’ nature of the future outlook, it is likely that the market has not yet reached equilibrium levels in terms of market expectations of the terminal repo rate. In Nomura’s base case, it expects an 8% terminal repo rate before a prolonged pause.

RBI announced its second half borrowing calendar yesterday, with an expected Rs2.35 trillion of issuance. This was consistent with market expectations. There were some concerns among market participants that the second half borrowing calendar would include another Rs500 billion of bond supply to account for 'debt switches' that the RBI is expected to conduct in second half of this fiscal year, concludes the Nomura research note.