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On the balance, market nervousness on supply and other external factors is placing upward pressure on bond yields while a healthy demand-supply equation is tempering the rise in yields. A sharp shift in one side, either positive or negative, will lead to either strong rallies or sharp sell off in bond yields.

The government is auctioning Rs 15,000 crore of bonds every week against the schedule of Rs 12,000 crore indicated in the borrowing calendar for the first half of fiscal 2009-10. The increase in weekly auction size is aimed at frontloading the government borrowing programme for the full year 2009-10 and is a measure to check excess liquidity in the system arising out of large government overdrafts with the Reserve Bank of India (RBI). The higher supply comes against the backdrop of a sustained rise in global bond yields and oil prices.

Global bond yields have moved up by almost 80 basis points (bps) over the last one month while oil prices are up by close to 100% from lows seen during this calendar. The rise in global bond yields is on account of worries of fiscal situation of governments and also on worries on account of inflationary pressures arising out of excess system liquidity.

The excess liquidity is due to central banks pumping in money into the system through asset purchases and this liquidity is taking up prices of commodities. The rising commodity prices are increasing inflation expectations, leading to interest rates starting to factor in higher inflation.

The increase in bond supply, coupled with rise in global bond yields and rise in oil and other commodity prices, is placing upward pressure on domestic bond yields. Ten-year benchmark bond yields have risen from lows of 6% to levels of 6.55% over the last one month. On the other hand this rise has been tempered by the inherent demand from the banking system. The banking system is seeing deposits grow by 22% and lending grow by 16% leading to excess funds being parked in government bonds.

Inflation as measured by the Wholesale Price Index (WPI) came in below market expectations of 0.56% at 0.48% for the week ended May 16, 2009. Inflation is close to all-time lows and is expected to go negative in the next few weeks on the back of high base effect, though inflation expectations are rising on the back of higher oil prices.

Liquidity, as measured by bids for reverse repo/ repo in the Liquidity Adjustment Facility (LAF) auctions remained high with bids for reverse repo crossing Rs 130,000 crore. Overnight rates were at 3% levels. Liquidity will continue to be high in the system, keeping overnight rates low.

Government bonds
Government bonds saw yields closing on a mixed note. The benchmark 10-year bond, the 6.05% 2019 bond, saw yields move down 14 bps to close the week at 6.55% levels. The benchmark paper is however, seeing no trading interest with trading becoming concentrated on auction papers. Trading last week was concentrated on the 7.59% 2016 bond which hogged almost 85% of trading volumes.The five-year benchmark bond, the 6.07% 2014 bond, saw yields close up 4 bps at 6.33% levels while the long bond, the 6.83%2039 bond, saw yields close flat at 7.75% levels.

The bonds auctioned last week were a new 6-year bond for Rs 8,000 crore, the 8.20% 2022 bond for Rs 5,000 crore and the 7.50% 2034 bond for Rs 2,000 crore. The cut-offs came in at 6.49%, 7.45% and 7.75% respectively. The bonds to be auctioned this week are the 6.07% 2014 bond for Rs 8,000 crore, the 7.94% 2021 bond for Rs 3,000 crore, the 8.24% 2027 bond for Rs 2,000 crore and the 7.40% 2035 bond for Rs 2,000 crore.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher in the auctions last week, with the cut-off on the 91-day T-bill auction held on June 3 coming in at 3.36% against a cut off of 3.32% in the previous auction.The 364-day T-bill auction saw cut-off coming in at 4%, against a cut off of 3.68% in the previous auction. The RBI is auctioning Rs 5,000 crore of 91-day T-bills and Rs 500 crore of 182-day T-bills this week.

Corporate bond yields were lower week-on-week on the back of buying at higher levels of yields. Five-year benchmark bonds traded at 8.1% levels down 5 bps week-on-week, while 10-year benchmark bonds traded at 8.65% levels down 10 bps week-on-week. Ten-year spreads closed up 4 bps at 199 bps levels while five-year spreads closed down 5 bps at 155 bps levels. Corporate bond yields are likely to track government bond yields this week.

Overnight index swaps (OIS) saw the curve flatten as the five-year OIS saw yields move down marginally while one year OIS yields moved higher. The five-year OIS yield closed down 3 bps at 6.2% levels while the one year OIS yield closed up 9 bps at 4.12% levels. The one-over-five spread moved down 12 bps to close at 212 bps levels. The five-year OIS yield is likely to be volatile on the back of uncertain interest rate environment.

Disclaimer: The author is head-fixed income, IDFC Mutual Fund and views are personal