Market over-extended itself in the bond auction

The market, which has been starving for a benchmark paper to trade, bid aggressively for the new 10-year bond in the government bond auction held last week.

The bidding saw the cut off on the 10-year bond coming in at 7.80%, almost eight basis points (bps) below the levels quoted when issued in the market.

The cut off was so aggressive that, in fact, traders found they did not want to hold the bond at such low levels of yields. Traders sold off their excess positions post cut off and the 10-year benchmark bond closed the week 6 bps higher than the cut off levels of 7.80%.

The market will now have to find a trading range for the 10-year bond. The range will likely be in the 7.75% to 7.95% band for a while. There are not too many unknowns in the market at present.

Oil prices are trending at multi-year highs of $126/bbl (Brent crude) and it does have an inflationary impact on the economy. The RBI is set to raise policy rates in their annual monetary policy for 2011-12 to maintain their vigil against inflation.

The government may also raise fuel prices after the state elections end in May. There will be a steady supply of bonds through government bond auctions every week. Given these factors, there is not much in terms of events or news to push bond yields much higher than 7.95% or take them to below 7.75%.

The swap market saw yields rise by 12 bps week-on-week. The 5-year OIS (Overnight Index Swap) yield closed last week at 8.08% levels while the 1-year OIS yield closed at 7.51% levels, up from 7.97% and 7.39% respectively.

The rise in swap yields against an aggressive cut off in the auction does suggest some amount of bond-swap positions being built in the market. A market short of bonds to sell but fearful of rate hikes and inflation has a tendency to hedge long bond positions with paid swap positions.

The market, in doing this trade, is playing for a scenario where swap yields rise much faster than bond yields. Higher swap yields are being supported by global events where rate hike by the ECB (European Central Bank) and rising oil prices are helping bond yields across geographies trend higher.

The 10-year US treasury yield rose 14bps week on week on the back of inflation worries.

Corporate bond yields at the mid and longer end of the curve moved higher by 3bps week on week with 5 and 10-year corporate bond yields closing last week at 9.21% and 9.18% respectively.

Corporate bond yields will remain sticky at higher levels, given the lack of direction for the market, while AAA credit spreads will move with movements in government bond yields. Five and 10-year credit spreads closed last week at 110bps and 115bps levels respectively. Five year spreads came off by 4bps while 10-year spreads rose by 15bps week on week.

Liquidity eased last week with the system going into surplus liquidity from negative liquidity seen in the week before last. Government spending coupled with release of built-up March liquidity flooded the system with funds. Bids for reverse repo at the LAF (Liquidity Adjustment Facility) auction of the RBI averaged Rs62,000 crore last week as against the average bids of Rs93,000 crore for repo seen in the week before last. Liquidity will continue to remain comfortable in the coming weeks.

Government bond auction
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were a fresh 7-year maturity bond for Rs4,000 crore, a fresh 10-year maturity bond for Rs5,000 crore and the 8.30% 2040 bond for Rs3,000 crore. The cut off came in at 7.83%, 7.80% and 8.41% respectively. The government is scheduled to auction Rs12,000 crore of bonds this week.