Short-term Indian government bond yields fell to their lowest in three months on Wednesday, steepening the yield curve to a one-year high on expectations that banks will invest funds raised under the RBI's dollar inflow measures in this segment.
On Friday, the Reserve Bank of India unveiled steps to attract dollar inflows, including fully subsidising hedging costs on foreign currency deposits raised from non-resident Indians.
The subsidy covers non-resident deposits with maturities of three to five years raised until September 30.
With the RBI absorbing hedging costs, banks can convert dollar deposits into rupees more cheaply, giving them access to lower-cost funding that is expected to flow into investments, including government bonds.
Yields on two- to five-year bonds have fallen by up to 30 basis points, led by the 6.36% 2031 bond, which has accounted for about $500 million of the roughly $1 billion in foreign purchases over the past three days.
"The rally is being driven by expectations that a portion of funds raised by banks under the RBI's scheme will be channeled into shorter-duration bonds," said Binod Kumar, managing director and CEO at Indian Bank.
The gap between five- and 10-year yields has widened to a one-year high of 40 basis points, more than double its pre-policy level. The five-year yield has fallen more sharply than the 10-year.
Ashwin Patni, head of wealth management solutions at Julius Baer India, said the short to medium end of the curve currently offers a more favorable risk-reward trade-off compared to the longer end, which remains more sensitive to global factors and fiscal dynamics.
Investors expect a further steepening of the curve, with more inflows likely in the coming days and the up-to-five-year segment remaining in favor.
"We expect incremental inflows to the tune of around $5 billion in the immediate future in response to these announcements, aided by tax exemptions and expectations of improved performance of INR vs other Asian currencies," Parul Mittal Sinha, head-markets, India and South Asia at Standard Chartered Bank, said.
