Explained: Recent surge in G-sec yields and how RBI can cap such rise

The report believes the central bank will have to resort to unconventional tools to control the surge in bond market yields.

“This is important as any further upward movement in G-sec yields even by 10 basis points from the current levels could usher in MTM losses for banks that could be a minor blip of a rather wise exceptional year in FY21 bond markets with the RBI assiduously supporting debt management of government at a lowest possible cost in 16 years, that otherwise could have threatened financial stability,” the report said.

In fact, RBI's strategy of devolving on the primary dealers may have its limitations as Standalone PDs account for 15-16 percent of secondary market share that may not be enough to move the market. This share has remained broadly consistent over a long period despite excessive market volatility.

The report further believes one of the reasons for the recent surge in yields might be short selling by market players. The strategy of short selling involves the sale of a security which the seller has not yet purchased but borrows the security from others in the market through the CROMS platform of CCIL.

"The banks and the primary dealers resort to short selling when their view is bearish - that is, the prices of the bond will fall and the yield will rise. They make money if the bond prices drop and yields rise, and over a point of time, this could become a self-fulfilling prophecy as such short sellers keep on rolling over their borrowed security from the repo market till the time they believe that yields will continue to rise," the report mentioned.

The only way to break such self-fulfilling expectations, according to the report, is for RBI to conduct large-scale OMOs to provide necessary steam to bond market to rally and with increase in price, many short sold position will trigger stop losses and market players will scramble to cover open positions.

Speaking to market players /off-market interventions:

This will also fulfill the desired objective of RBI avoiding devolvement at auctions.

OMO in illiquid security: OMO in illiquid security will help shorters (hedgers) to get relieved of those holding in OMO and unwinding of short position will happen, if the selling pressure is matched by an equivalent or better buying pressures from the market participants. Announcing a weekly outright OMO calendar of Rs 10000 crore till March end will be helpful.

Stopping VRR rollover: With even short end Gsec yield (3 year Gsec at 4.9 percent and 5year Gsec at 5.85 percent), Corp bond yields higher too (3year AAA at 5.55 percent) the entire benefit of accommodative stance is neutralized. VRR is not helping in overnight rates as can be seen in last week's treps rate which was averaging 2.4 percent.

Holding period: The time period for covering short sale may be reduced from 90 days to 30 days.

Margin Requirement: Margin requirement for borrowing securities in repo market while covering the short sale position may help. Short sellers may deposit collateral to the tune of 150 percent of the value of short security.

Limit reduction: The security level limit may be reduced to 1 percent of outstanding stock (or Rs 300 crore) of each security in case of liquid securities and 0.5 percent (or Rs 150 crore) in case of illiquid securities.

Allowing More players: Allowing more players such as mutual funds and insurance companies in the repo market.

Penalizing short sellers: The short sellers are even willing to give the money at 0.01 percent for borrowing bonds. Can we have not a system of negative interest that will make the transaction even costlier for them? RBI can also supply bonds in the repo market to the short-sellers if it has the stock.