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The market has started to look forward to April 2010 when government borrowing for 2010-11 will commence. The new borrowing programme will see the issuance of a new ten-year benchmark security.

The market, anticipating a new benchmark bond, has started to offload the current ten-year bond, the 6.35% 2020. The note is no longer the ten-year on-the-run bond and the right levels of the ten-year bond will only be known in April when the first of the new ten-year benchmark bond issuances begin.

The market offloading of the 6.35% 2020 bond has taken the yield up by 14 basis points (bps) week on week to 8% levels. Given the lack of alternatives for the 6.35% 2020 bond, the market is shifting to the 7.02% 2016 bond as a substitute.

Trading volumes in this bond have moved higher than the volumes in the 6.35% 2020 bond. The spread between the 6.35% 2020 bond and the 7.02% 2016 bond has widened from 17 bps to 30 bps over the last one month.

It may be noted that the 6.35% 2020 bond came in as a replacement on-the-run bond to the then benchmark ten-year bond, the 6.90% 2019. Trading in 6.90% 2019 bond has virtually stopped from the time the market embraced the 6.35% 2020 bond as a replacement. The 6.35% 2020 bond will suffer a similar fate to that of the 6.90% 2019 bond and it is advisable for market participants to exit the bond before liquidity vanishes.

The union budget for 2010-11, which was presented to the parliament on the February 26, set the direction for bond yields. The budget is seen as inflationary with a rise in government spending and excise duties. Fuel prices were raised immediately after the budget, leading to expectations that inflation as measured by the wholesale price index (WPI) will touch double-digit levels in the next couple of months.

The budget has also unveiled a Rs 457,000 crore gross borrowing programme of the government for 2010-11.

The government has indicated that the borrowing will be front-loaded with 70% of the borrowing being completed in the April-September period. The average weekly issuance of Rs 13,000 crore will have to be absorbed by the market in an environment of rising inflation expectations and prospects of policy rate hikes by the Reserve Bank of India (RBI).

The market is decidedly nervous on the levels of yields at which the auctions are likely to get cleared and has started taking up bond yields as a preemptive measure.

Liquidity
Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of the RBI was comfortable, with bids for reverse repo at 3.25% at around Rs 70,000 crore.

Liquidity was comfortable despite the cash reserve ratio (CRR) hike of 25 bps sucking out Rs 13,000 crore from the system. Overnight rates were at reverse repo levels of 3.25% and are likely to remain around reverse repo rate levels till such time as advance tax outflows hit the system (third week of March).

Government bonds
Government bonds saw yields move up across the curve, on inflation and government borrowing worries. The ten-year6.35% 2020 bond saw yields close the week at 7.97% levels, up 11 bps week on week, while the five-year 7.32% 2014 bond saw yields close up 2 bps at 7.34% levels. The 7.02% 2016 bond saw yields close flat at 7.67% levels and the 8.24% 2027 bond yield closed higher by 4 bps at 8.4% levels.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were higher in the 91-day auction held on March 3, with the cut-off coming in at 4.22% against acut-off of 4.13% seen in the previous auction.The 182 day T-bill auction saw the cut off coming in at 4.7% against 4.55% seen in the previous auction. The RBI is auctioning Rs 5,000 crore of 91-day T-bills and Rs 3,000 crores of 364-day T-bills this week.

Corporate bonds saw yields close flat week on week at the longer end of the curve.Five- and ten-year corporate bond yields closed last week at 8.65% and 8.95% levels, respectively. Primary supply and muted investor demand will keep corporate bond yields pressured at the long end of the curve. The corporate bond yield curve steepened with one and three-year yields coming off by around 15 bps. The market saw good bidding interest in these segments on reduced fears of a liquidity crunch in March.

Overnight index swaps (OIS) saw the curve move up week on week. The five-year OIS yield closed higher by 2 bps at 7.04% levels, while the one year OIS yield closed up 4 bps at 5.01% levels. The one-over five spread closed down 2 bps at 203 bps levels. The OIS curve is likely to trade in a tight range given high carry costs deterring payers and inflation and rate hike worries deterring receivers.

Disclaimer: The writer is head – fixed income, IDFC Mutual Fund. Views are personal.