Dysfunction in Bond Market

Interest rates paid by the borrowers are determined by the following variables:

• Term premium: The difference between the repo rate and the government’s borrowing cost, say on a 10-year loan, is called the term premium.
• Credit spread: When a private firm takes a 10-year loan, it would have some credit risk too, which means a credit spread (involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices) is added to the 10-year risk-free rate.

Cost of borrowings by the Government: There are two opposing views on whether the cost of borrowing by the government should actually matter so much in the post-pandemic recovery -

• Cost of borrowing does not matter much: The interest on government debt is a transfer from taxpayers to savers (who own government bonds), and thus, tax for one is income for the other.
  • Thus, unlike private borrowers, who are greatly concerned about their cost of borrowing, decision-makers in governments are not directly affected by the interest rates on offer.
• Cost of borrowing does matter:
  • Limits government spending: The large increase in debt to GDP last year means interest costs as a share of GDP could be 1% point higher than earlier (for state + central governments), limiting its ability to spend elsewhere.
  • Affects the borrowing cost: Term premium and credit spread pose a challenge.
    • Term premium has been the highest in the world - the 10-year term premium is currently 215 basis points, having risen by 35 basis points since the budget presentation.

Factors that reflect the dysfunction in the bond market: While it was being anticipated that the government cost of borrowing would go down due to the high collection from the earlier projected bond issuance and reduction the fiscal deficit of the 14 states (to 3.3%, (mandated-4%)), it did not happen. Reasons are -

• Unpredictability: The Indian bond market is still too illiquid and not diverse enough to predict trends.
• High presence of residential mortgages: Which are among the most competitive of loan categories, one where even public sector banks are active.
• Structural shortage in demand for government bonds: In such a market, the marginal buyer holds all the cards, and as any buyer would, demands higher returns.
• Falling share of banks in the ownership: Over 15 years, the share of banks in the ownership of outstanding central government bonds has fallen from 53% to 40% now.
• Exclusion of Indian bonds from global bond indices: Foreign Portfolio Investment (FPIs) flows may not be meaningful and would be volatile, as they have been over the past year.

Way forward: Measures to ensure the cost of borrowing in the economy is conducive for recovery:

• Getting the new type of buyers: The RBI opening up direct purchases by retail investors is a step in this direction, though it may not become meaningful for a few years.
• Enable inclusion in bond indices: RBI and the government have earmarked special-category bonds which are fully accessible (FAR) by foreign investors.
  • Financial Times Stock Exchange (FTSE) has come forward to place India on the watch-list for “potential future inclusion” in the Emerging Markets Government Bonds Index, which triggers similar actions by other index providers.