Sri Lanka bond rates rise to straighten inverted yield curve

Oct 10, 2012 (LBO) – Sri Lanka’s bond rates have risen by 40 to 50 basis points over two days almost ending an inversion of the yield curve where short term Treasuries yielded higher than longer term gilts.

But expectations of lower inflation in the future, which can shift more short term money to the longer end increasing the willingness of investors to lock in to longer term rates, as well as an actual reduction in the sale of new bonds, can invert the yield curve.

Bond yield fell after the Central Bank remained firm on keeping its overnight interest rate at 9.75 percent in its September monetary policy review, indicating that future inflation will fall.

But last week the monetary authority injected money in to the banking system through a term auction, undermining its own monetary policy stance.

Though Sri Lanka has a history of high interest rates and policy rates – much higher than the anchor US currency – which should have allowed the country to maintain a peg with the US dollar and keep inflation down easily.

But analysts say periodic injections of cash into the banking system, either as provisional advances or large scale Treasury bill purchases through opaque processes have tended to keep inflation high and weaken the exchange rate.

A term auction however is a transparent monetary process.

A bond maturing on April 01, 2014, with a tenor a little over a year, moved up to 12.05/25 percent Tuesday from 11.55/65 levels on two days earlier, dealers said.

A 3-year bond maturing on July 15, 2015 rose to 12.15/25 percent levels from 11.65/75 percent levels over two days.

A 5-year July 15, 2017 bond was quoted around 12.30/40 percent Tuesday up from 11.80/85 percent levels two days earlier.

However bonds still sharply down from September when five year bonds were quoted around 14.35 percent levels.

On Tuesday one year bills were quoted around 12.25 percent, reducing the inversion of the yield curve.

On October 03, when one year bills yielded 12.48 percent at the weekly Treasuries auction the three year bond traded at 12.30 percent in the secondary market and dropped further in the next few days.

The steeply falling bond yields inverted the yield curve over the past month, leaving short term rates higher than the longer end. Short term yield then fell to catch up with longer terms ones, until the recent spike in bond yields this week.

Under normal circumstances, longer maturities that expose creditors for a longer period tend carry a higher yield.