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The bond market is facing negative news from many fronts at the same time, which can potentially take up yields from current levels. The negatives bond yields are facing now are supply, global bond yields and oil prices.

On the supply side, the government increased the auction size for last week and this week by Rs 3,000 crore each. The higher supply came as a surprise and the market fears increased borrowings in the subsequent auctions.

Global bond yields rose sharply on the back of fears of sovereign rating downgrades for AAA rated economies of the UK and US. US ten-year benchmark treasury yields closed at 3.45% up 33 bps week-on-week. The large fiscal deficits these economies are running are placing pressure on their ratings.

Oil prices moved over $60/bbl on the back of a weak dollar leading to inflation fears. Oil prices are up almost 100% from lows seen during the year.

The market is faced with additional uncertainty on the fiscal and monetary front. The government is set to present the budget for 2009-10 in July. The market is hopeful that the government can reign in fiscal deficit through divestments and 3G auctions, but there are pressures from many quarters for higher spending to stimulate the economy.

The Reserve Bank of India (RBI) has indicated that it will wait and watch till the third quarter of 2009-10 for any additional policy measures. It has also sounded caution on the fiscal deficit though it has reiterated its commitment for a smooth borrowing programme.

This week will see the government auctioning Rs 15,000 crore of bonds. The bonds to be auctioned are out of the schedule, with Rs 6,000 crore of supply at the long end. The original schedule as per the borrowing calendar was for bonds in the 5-9 year and the 10-14 year bucket. The revised schedule will add to the negative sentiments in the market. Ten-year benchmark bond yields have risen by 6 bps on the back of higher supply and negative global factors.

Inflation as measured by the wholesale price index (WPI) came in as per market expectations at 0.61% for the week ended May 9, 2009. Inflation is close to all-time lows and is expected to go negative in the next few weeks on the back of the high base effect. Liquidity, as measured by bids for reverse repo/repo in the liquidity adjustment facility (LAF) auction of the RBI, remained high with bids for reverse repo crossing Rs 1,30,000 crore. Overnight rates were at 3% levels. Liquidity will continue to be high in the system, keeping overnight rates low.

Government bonds
Government bonds saw yields move up on the back of higher supply. The benchmark ten-year bond, the 6.05% 2019, saw yields move up by 6 bps to close the week at 6.48% levels. The yield on the five-year benchmark bond, the 6.07% 2014, closed up 10 bps at 6.07% levels while the long bond, the 6.83%2039, saw yields close up 5 bps at 7.55% levels.

The RBI purchased Rs 4,500 crore of bonds through open market operations (OMO) last week. The bonds purchased were the 8.24% 2018 at 6.69%, the 8.35% 2022 at 7.26%, 8.28% 2032 at 7.47% and the 8.33% 2036 bond at 7.50%. The government auctioned Rs 12,000 of bonds last week. Those auctioned were the new five-year benchmark, the 6.07% 2014 bond for Rs 6,000 crore, the 6.35% 2020 bond for Rs 5,000 crore, the 8.24% 2027 bond for Rs 2,000 crore and the 7.50% 2034 bond for Rs 2,000 crore. The cut-offs came in around market expectations at 6.09%, 6.85%, 7.49% and 7.56%, respectively.

The bonds to be auctioned this week are the 7.59% 2016 for Rs 6,000 crore, the 7.94% 2021 for Rs 3,000 crore, the 8.24% 2027 for Rs 3,000 crore and the 7.40% 2035 bond for Rs 3000 crore.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were flat at the 91-day T-bill auction last week. The cut-off at the 91-day bill auction on May 20 came in at 3.28% against a similar cut-off seen in the previous auction. The 364-day T-bill auction saw the cut-off at 3.68% against a cut-off of 3.5% seen in the previous auction. The RBI is auctioning Rs 5,000 crore of 91-day T-bills and Rs 2,000 crore of 182-day T-bills this week. Corporate bond yields were higher week-on-week on the back of a rise in government bond yields. Five-year benchmark bonds traded at 7.95% levels, up 25 bps week-on-week, while ten-year benchmark bonds traded at 8.65% levels, up 5 bps week-on-week.

Ten-year spreads closed at 208 bps levels while five-year spreads closed at 153 bps levels. Corporate bond yields are likely to track government bond yields this week. Overnight index swaps (OIS) saw the curve steepen as the five-year OIS saw good paying interest at higher levels on the back of rise in global bond yields.

The five-year OIS yield closed up 36 bps at 6.03% levels while the one-year OIS yield closed up 4 bps at 3.91% levels.

The one over five spread moved up 32 bps to close at 212 bps levels. The five-year OIS is likely to start trading higher than the five-year government bond yield in the coming weeks.