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The fourth quarter of the current fiscal is going to be tough for bond markets from supply point of view. The government is scheduled to borrow Rs1,20,000 crore and Rs1,50,000 crore through issuance of dated bonds and treasury bills, respectively, in January-March 2012. Over and above the borrowing, states will also step into the market to borrow around Rs6,000 crore every fortnight. The heavy supply of bonds will push up bond yields unless RBI steps in with increased quantum of bond purchases through Open Market Operations (OMOs), lowering the Cash Reserve Ratio (CRR) and cutting policy rates.

The government increased the size of its borrowing for the second half of 2011-12 by Rs40,000 crore on the back of worsening finances. The Rs40,000 crore additional supply is on top pf the Rs53,000 crore jump in the borrowing for fiscal 2011-12, taking the total government borrowing for the fiscal to Rs5,18,000 crore.

RBI will absorb the most of the higher borrowing of Rs93,000 crore by buying bonds in the secondary markets through bond purchase auctions. The central bank has bought around Rs41,000 crore of bonds over the past five weeks and will continue with its bond purchase to reduce the impact of higher government bond supply on bond yields.

Yields rose sharply across the curve due to worries of higher supply. The 10-year benchmark bond — 8.79% 2021 — saw yields rise by 21 bps week on week to close at 8.58% level while the yield on the well-traded 9.15% 2024 bond went up 25 bps week on week. Yields will rise 10-15 bps before stabilising on hopes of policy rate cuts and more RBI bond purchases.

Corporate bond yields showed an upward trend with the 5-year benchmark AAA yields rising 15 bps and 10-year benchmark AAA climbing 10 bps week on week. Higher government borrowing will only add to the pressure on corporate bond yields, and 5- and 10-year benchmark yields will edge up 15-20 bps in coming weeks.

The swap curve saw the five over one Overnight Index Swap (OIS) spread, which is inverted, flattening 15 bps week on week. The spread came off from -78 bps to -62 bps as 5-year OIS yields rose in step with government yields. The five-year OIS one rose 13 bps week on week while that of 1-year OIS fell 3 bps week on week. The OIS curve will be pressured as government yields creep up with 5-year OIS yields rising faster than 1-year OIS.

Liquidity as measured by bids for repo in the Liquidity Adjustment Facility (LAF) auction of the RBI eased last week on the back of OMO purchases and government spending. Bids for repo averaged Rs1,23,000 crore last week on a daily basis against an average of Rs1,67,000 crore seen in the week previous to last.

Liquidity will continue to ease in coming weeks with RBI bond purchases, though on an overall basis, system liquidity will be tighter than RBI’s comfort levels.

The primary article inflation came off to levels of 2.7% for the week ended December 17. This is at over 2-year lows and has come off significantly from highs of 13.3% seen in August. Food inflation has crashed to levels of 0.42% from those of 10% seen in August. The drop in primary article inflation will bring down inflation expectations and help RBI in its efforts to ease its policy stance.

Government bond auctions
The government auctioned Rs15,000 crore of bonds last week, in an unscheduled event. The bonds auctioned were the 7.99% 2017 paper for Rs3,000 crore, the 9.15% 2024 one for Rs6,000 crore, the 8.28% 2027 bond for Rs3,000 crore and the 8.83% 2041 bond for Rs3,000 crore. The cut-offs came in at 8.55%, 8.70%, 8.90% and 8.82%, respectively. The government is auctioning Rs14,000 crore of bonds this week.

RBI bought Rs8,109 crore of bonds through OMOs last week. The bonds bought were the 7.83% 2018 paper for Rs5,235 crore at an yield of 8.41% and the 7.80% 2021 bond for Rs2874 crore at an yield of 8.45%.

The writer is editor,ww.investorsareidiots.com, a website for investors.