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The rally in the bond market, which took yields down by 20-30 basis points across the curve, may stall if the government front-loads its borrowing for the fiscal 2009-10.

Finance minister Pranab Mukherjee will present the Union Budget for 2009-10 on Monday, and is likely to show an additional borrowing of around Rs 50,000 crore over and above the target set in the vote on account in February 2009.

The front-loading of the additional borrowing serves the purpose of a) leaving room to borrow more in the second half of the fiscal if required; b) pay for pay commission and farm loan waiver expenditures to be incurred this quarter; c) absorb excess liquidity in the system; and d) take advantage of lower bond yields when the wholesale price index is in negative territory.

The government is slated to borrow Rs 97,000 crore in the July-September quarter and any amount borrowed over and above Rs 97,000 crore will impact bond yields. The government had raised an additional Rs 18,000 crore from a target of Rs 1,44,000 crore in the April-June quarter. The higher amount raised in the last quarter took up bond yields by 100bps from lows seen in May 2009.

The rise in bond yields on the back of front-loading of government borrowing is however, likely to be capped. The macro environment is looking more favourable for bond yields with global economic growth looking anaemic with unemployment ruling at close to 10% levels.

Commodity prices have come off from six-month highs on worries of slow economic growth. Inflation is still some way off with high unemployment and low economic growth curbing demand.

Central bank buying of bonds is a comforting factor for the market given the high levels of supply. The Reserve Bank of India has been buying government bonds to add primary liquidity in the system.

Inflation as measured by WPI came in below market expectations of negative 1.38% at negative 1.30% for the week ended June 20, 2009.

Inflation is expected to remain in the negative zone for the next few weeks on the back of high base effect.

Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility auction of the RBI remained high with bids for reverse repo crossing Rs 1,50,000 crore. Overnight rates were at 3% levels. Liquidity will continue to be high in the system keeping overnight rates low.

Government bonds
The most traded bond, the five-year benchmark — 6.07% 2014 bond — saw yields close down 28bps at 6.22% levels week-on-week. The recently auctioned 7.94% 2021 bond saw yields come off by 34bps to close at 7% levels. The long end of the curve saw yields come off by 15bps with the yield on the 7.40% 2035 bond closing at 7.75% levels from 7.90% levels. Government bond yields will take direction from the Union Budget.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were lower in the 91-day T-bill auction held last week, with the cut-off on the 91-day T-bill auction held on July 1 coming in at 3.11% against a cut-off of 3.32% in the previous auction. The 364-day T-bill auction saw the cut-off coming in at 3.81%, against a cut-off of 3.99% in the previous auction. The RBI is auctioning Rs 8,000 crore of 91-day T-bills and Rs 1,500 crore of 364-day T-bills this week.

Corporate bond yields were lower week-on-week on the back of a rally in government bond yields. Five-year benchmark bonds traded at 7.85% levels down 20bps week-on-week while 10-year benchmark bonds traded at 8.50% levels, down 15bps week-on-week. Five-year spreads closed flat at 150bps levels, while 10-year spreads closed flat at 158bps levels. Corporate bond yields are likely to take cue from the Union Budget.

Overnight index swaps (OIS) saw the curve almost flat week-on-week. The five-year OIS yield closed up 3bps at 6.15% levels while the one-year OIS yield closed down 3bps at 4.12% levels. The OIS curve is likely to follow government bond yields this week.

Disclaimer: The author is head - fixed income, IDFC Mutual Fund. Views are personal.