Bonds Fall for Third Quarter as Real Yields Trail Treasuries: India Credit

India’s bond yields are poised to rise for a third consecutive quarter as the central bank struggles to cool inflation.

The benchmark 10-year yield may climb nine basis points to 8.19 percent by the end of March, after increasing 18 basis points since Dec. 31, according to the median estimate of five primary dealers in a Bloomberg survey. Kaushik Basu, the finance ministry’s chief economic adviser, said in a Jan. 5 interview that the inflation rate is “too high,” and Masahiko Takeda, the International Monetary Fund’s India mission chief, said in a statement yesterday interest rates may need to be increased.

Finance Minister Pranab Mukherjee said last month wholesale prices will be rising at a 6.5 percent pace by the end of March, above a previous estimate of 6 percent, because of surging food and oil prices. Yields on India’s 10-year government bonds are 62 basis points above inflation, compared with 330 in the U.S. and 111 in Japan.

“Commodity prices are at significantly high levels, and we haven’t seen the complete pass-through of that in inflation,” Nirav Dalal, Mumbai-based head of debt capital markets at Yes Bank Ltd., partly owned by Rabobank Nederland NV and HSBC Holdings Plc, said in an interview on Jan. 3. “Bond yields at current levels don’t adequately capture that.”

Repurchase Rate

Food prices rose at an 18.3 percent rate in the week ended Dec. 25, the most since July, according to a commerce ministry report issued yesterday, prompting Mukherjee to say the acceleration is an “area of concern.” The data threaten progress made in curbing wholesale prices, which India uses as its barometer for inflation. Gains in wholesale prices slowed to an 11-month low of 7.48 percent in November. Food makes up about 14 percent of the benchmark index.

The Reserve Bank of India lifted the repurchase rate by 150 basis points last year to contain the surge in prices. The repurchase rate, at which lenders borrow from the central bank, may rise 25 basis points to 6.5 percent at the next review on Jan. 25, according to 11 of 16 economists in a Bloomberg survey. The rest forecast no change.

“The way inflation is, even the finance ministry people are changing their stance,” Pradeep Madhav, managing director at the Mumbai-based Securities Trading Corp. of India, said in an interview on Jan. 3. “I would think there would be a rate hike in January.” He predicted the benchmark yield will be 8.15 percent by the end of March.

Bond Underperformance

Of the other primary dealers surveyed, Axis Bank Ltd. and Royal Bank of Scotland NV concurred with Securities Trading Corp.’s assessment. Both ICICI Securities Primary Dealership Ltd. and IDBI Gilts Ltd. forecast the yield will increase to 8.25 percent.

The 10-year yield jumped 29 basis points in the third quarter of 2010 and eight basis points in the fourth quarter.

Investors would still earn an annualized return of 5.2 percent if the prediction by the primary dealers proves accurate, according to Bloomberg data. That would compare with the 5.3 percent the securities gained during the past 12 months, according to indexes compiled by HSBC Holdings Plc. Indonesian securities handed investors 24 percent, the most in the region, while Philippine notes delivered 12.5 percent.

Rupee’s Gain

India’s 10-year bond yield is the highest among Asia’s 10 biggest economies. The comparable rates are 7.66 percent in Indonesia and 3.79 percent in China. The real, or inflation- adjusted, yield in Indonesia is 71 basis points and a negative 131 in China. The difference in rates between India’s debt due in a decade and similar-maturity U.S. Treasuries was 469 basis points today, up 89 basis points from last year’s low.

India’s rupee rose 0.5 percent last quarter, the third- worst performance among Asia’s 10 most-traded currencies, as rising commodities prices aggravated food inflation. The currency declined 0.3 percent to 45.39 per dollar today.

The cost of protecting the debt of government-owned State Bank of India, which some investors perceive as a proxy for the nation, has increased 36 basis points since the start of 2010 to 154, according to CMA prices. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Borrowing Target

The outlook for bonds beyond March will rest partly on the finance ministry’s borrowing plan, according to Dhawal Dalal, head of fixed-income investments in Mumbai at DSP Blackrock Investment Managers Pvt. The federal government’s borrowing target in the current financial year is 4.47 trillion rupees ($98.5 billion), compared with a record 4.51 trillion rupees in the previous fiscal year.

“The key question the market will have to ask is ‘what the government’s expenditure will be next fiscal year?’,” Dalal said in an interview on Dec. 3. “The borrowing program will be an important factor.”

Basu, the chief economic adviser who studied at the London School of Economics, said in his interview that policy makers will withdraw fiscal stimulus to tame inflation.

“You will see steps being taken this year, next year and maybe the year after,” Basu, 58, said in the interview ahead of next month’s budget presentation for the next financial year by Mukherjee.

The IMF’s Takeda said there is “a possibility” that further monetary tightening may be needed to contain inflation. Those comments, made in a video on the IMF’s website, came after the fund completed an annual review of India’s economy.

The Reserve Bank, which raised borrowing costs the most of any monetary authority in Asia last year, still isn’t finished with its task, according to ICICI Securities Primary Dealership.

“Inflation is still higher than the central bank’s comfort zone,” Prasanna Ananthasubramaniam, the Mumbai-based chief economist at the unit of India’s second-biggest lender, said in an interview on Jan. 5. “The central bank will still be on their toes to tackle it.”