Govt goes wrong with auction timing

Short sellers of government bonds had a great beginning in the new fiscal year. Traders who shorted them at March end in the first bond auction of the year made smart gains as yields rose 20 basis points (bps). The well traded 9.15% 2024 paper, which was an auction stock, saw the cut-off coming in at 8.84%, up 21 bps against the closing yields of 8.63% seen on the last trading day of March.

The first auction of the fiscal year 2012-13 was thus badly timed and poorly positioned. Coming to timing, there were only two trading days in the first week of April and there was not enough time for underwriters to offload auction positions.

The threat of devolvement forced primary dealers to bid defensively in the auction, as they did not want to be saddled with devolved stocks in a short trading week.

The auction was held on the first trading day of April, that is April 2, and the market did not even get time to judge the demand for the auction. Markets were bidding blindly and when bids are blind in a tough interest rate environment, these will be at higher levels of yields.

The auction was poorly positioned, as the size of Rs18,000 crore was the highest single event in terms of size. The first week of April is always tricky as the system is barely recovering from a tough March-end and liquidity is usually constrained. There was no real necessity for a large auction to be held in a difficult week. This actually helped short sellers make money at the cost of higher interest rates for the government.

Markets will come back to normal this week as the next auction size is Rs15,000 crore. And liquidity will be more comfortable as March-end positions find their way back into the system. Traders will also be looking to cover their shorts at higher levels of yields as the RBI is widely expected to cut benchmark rates in its annual policy on the April 17.

Ten-year benchmark bond yields will trend down from levels of 8.69% as the market goes into the policy.

The yields fell last week on expectations of easing liquidity and policy rate cuts. One  year Certificate of Deposit (CD) yields fell 10 bps week on week to 10% while the 91- day treasury bill auctions cut off came in lower by 21bps. And these will trend down further as rate cut expectations gain ground.

Overnight Index Swaps (OIS) yields were higher in the 5-year segment as these moved up 3 bps week on week on the back of rising government yields. The OIS yield curve, which is inverted with 1-year OIS yields at 8.02% and 5-year at 7.60%, will see the inversion coming off fully as the RBI cuts repo rates.

Traders should play for inversion coming off and then, the curve steepening by receiving the 1-year OIS and paying the 5-year ones.

Government bond auctions and OMOs
The government auctioned Rs18,000 crores of bond this week. The bonds auctioned were the 8.19% 2020 bond for Rs4,000 crore, the 9.15% 2024 bond for Rs8,000 crore, the 8.97% 2030 bond for Rs3,000 crore and the 8.83% 2041 bond for Rs3,000 crore, whose cut-offs came in at 8.76%, 8.84%, 9% and 9.06%, respectively.

The RBI devolved Rs319 crore of 8.19% 2020 bond and Rs875 crore of 8.97% 2030 bond on to primary dealers. The auction response was muted with bid to cover ratio at 1.6 times against over two times usually seen in government bond auctions.

The writer is the editor of www.investorsareidiots.com, a website for investors