Bond yields set to decline in coming months

The 10-year benchmark bond yield touched multi-year highs of 8.30% last week on the back of Reserve Bank of India’s policy actions. The 7.80% 2021 government bond yield rose to levels of 8.30% post policy from pre-policy levels of 8.13%, a jump of 17 basis points (bps). Investor buying and short covering at higher levels took down the yields from 8.30% to levels of 8.18%, where it closed last week.

The market has seen the highs on the ten-year bond and while it may briefly test the 8.30% levels once again, yields will be on a sustained downtrend in the coming months.

The fundamentals for the bond market are improving. The repo rate hike of 50 bps by the RBI in the annual monetary policy meet for 2011-12 takes the repo rate to 7.25%. Repo rate has been hiked 250 bps over the last one year and while the RBI stance is anti-inflationary, the RBI is on its last legs of rate hikes (or no hikes at all).

The RBI has hedged its bets on inflation by being extremely pessimistic on inflation. RBI forecast of inflation as measured by the WPI, or wholesale price index, is that it will trend at 8.5% to 9% levels for the first half of fiscal 2012 and then trend down towards 6% levels in the second half of the year. The RBI has factored in fuel prices hikes by the government in their inflation estimates.

The government is expected to raise petrol and diesel prices to pass on rising crude oil prices to the consumer. Crude oil prices at $109/bbl (Brent) is up close to 22% year-to-date and this is increasing the government’s subsidy bill which is touching close to Rs200,000 crore assuming oil prices remain at higher levels.

The government is keen on containing its fiscal deficit to budgeted levels of 4.6% of GDP and hence will raise fuel prices to bring down the subsidy bill. Inflation even if it does print at 9% levels in the coming months will not alarm the RBI and the market will not fear any surprise rate hikes in the coming months.

Liquidity, which was in deficit for most past of fiscal 2010-11, has come back into surplus mode. Government spending has infused over Rs50,000 crore of liquidity into the system. The government has borrowed from the RBI through the WMA (ways and means advances) window to pay out tax refunds (government has refunded over Rs70,000 crore in April).

The government which had unspent surpluses with the RBI for most part of last year, thereby draining liquidity from the system, is now borrowing and spending which infuses liquidity into the system. Banks, too, are seeing deposits grow at higher levels than last year as deposit rates have gone up by at least 300 bps over the last year. Bank deposit growth is trending at over 17% as of April 2011 against growth levels of below 15% seen in December 2010. Liquidity in positive territory is good for the bond market as cost of liquidity is capped.

The swap market saw the five over one spread flatten by 16 bps to close last week at 24 bps levels. The one-year OIS (overnight index swap) yield rose 16 bps week on week to close at 8.05% levels while the five-year OIS yield closed flat at 8.29% levels. The one-year OIS yield rose on the back of rate hikes while five-year yields came off from highs of 8.40% seen during the week as the market covered paid positions. The curve is likely to steepen from current levels once the market starts believing that RBI may not hike rates in their June review.

Corporate bonds are likely to see yields trend down as the market starts buying into absolute levels of yields. Five- and ten-year AAA benchmark corporate bond yields are trading around 9.45% and 9.36% levels, respectively and given that liquidity is not in deficit and government bond yields have peaked or at close to peaks, the market will have that much more comfort in buying into yields.
Government bond auction

The RBI auctioned Rs6,000 crore of cash management bills last week. The cut-off on the 77-day bill came in at 8%. The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 7.59% 2016 bond for Rs4,000 crore, the 8.13% 2022 bond for Rs5,000 crore and the 8.26% 2027 bond for Rs3,000 crore. The cut-offs came in at 8.40%, 8.40% and 8.60%, respectively. The government is scheduled to auction Rs12,000 crore of bonds this week.