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The uncertainty premium built in bond yields will go away as political and macroeconomic factors favour lower bond yields.

On the political front, the decisive win in national elections for the ruling party takes away fears of a new government policy that could have worsened the fiscal position of the government. The ruling party has a track record of bringing down fiscal deficit, and given their strength in Parliament, they can set right government finances over the next five years.

On the macroeconomic front, the optimism over economic recovery has dampened with weak economic data coming in on the domestic and global front.

On the domestic side, the year-on-year index of industrial production (IIP) growth for March 2009 came in weaker than expected at negative 2.3% against expectations of a negative 0.70%.

The growth for full year 2008-09 is at 2.4% against 8.5% in the previous year.

On the global front, Germany saw deeper than expected recession while the US saw weak retail sales and weak unemployment numbers. Exports across regions, including China, saw over 20% negative growth for April 2009. The global economic weakness brought down oil prices from $60 a barrel to levels of $56/bbl, while bond yields fell around 20bps from the highs seen last week.

Bond yields, which had sold off on economic and political uncertainty, will correct in this week and the 10-year benchmark bond yield is expected to trend down from current levels of 6.43%.

The other positives for the bond market are high system liquidity, low market leverage, Reserve Bank of India bond purchases and inflation looking to turn negative in the next few weeks.

System liquidity is ruling at around Rs 1.3 lakh crore levels and is likely to remain high given the lack of demand for liquidity in the economy.

The banking system is just around 2-3% over their statutory liquidity ratio requirement of 24% and given the high system liquidity, the banks can take in more government bonds, which are available at attractive spread of over 3% over the reverse repo of 3.25%.

RBI is committed to buy Rs 80,000 crore of bonds in the first half of fiscal 2009-10 leading to the large government borrowing going smoothly.

Inflation as measured by the wholesale price index is expected to go negative in the next few weeks on the back of high base effect. Inflation is ruling at 0.48% as of week ended May 2, 2009.

Liquidity as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of RBI remained high, with bids for reverse repo crossing Rs 1.3 lakh 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 mixed yield movements on account of expectations of change in benchmark. The benchmark 10-year bond, the 6.05% 2019 bond, saw yields move up by 5bps to close the week at 6.42% levels. The old five-year benchmark — the 7.56% 2014 bond — saw yields close up 10 bps at 6.15% levels while the long bond — the 6.83%2039 security — saw yields close flat at 7.50% levels.

The new five-year benchmark bond, the 6.07% 2014 note, saw yields close down 10bps at 5.97%. The market is expecting an issuance of a new 10-year benchmark bond, placing pressure on yields on the current benchmark.

The government auctioned Rs 12,000 of bonds last week. The bonds auctioned were a new five-year bond for Rs 8,000 crore and the 8.20% 2022 bond for Rs 4,000 crore.
The cut-offs came in at 6.07% for the five-year bond and 7.35% for the 2022 bond. The bonds saw good trading interest post auction, with yields closing lower on the back of good demand.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher in the 91 day T-bill auction last week, with the cut-off for the 91 day T-bill auction held on May 6 coming in at 3.28% against a cut-off of 3.15% seenin the previous auction. The 182 day T-bill auction saw the cut off coming in at 3.49% against a cut off of 3.55% in the previous auction. RBI is auctioning Rs 5,000 crore of 91 day T-bills and Rs 1,000 crore of 364-day T-bills this week.

Corporate bond yields were higher week-on-week on the back of rise in government bond yields. Credit spreads were flat, as corporate bond yields tracked government bond yields. Five-year benchmark bonds traded at 7.70% levels, up 10bps week-on-week, while the 10-year benchmark bonds traded at 8.60% levels, up 5bps week-on-week.

Ten-year spreads closed at 208bps levels while five-year spreads closed at 150bps levels. Corporate bond yields are likely to track government bond yields this week.
Overnight index swaps (OIS) saw the curve move down on higher levels of yields. The one year OIS yield closed down 5bps at 3.87% levels, while the five-year OIS yield closed down 5bps at 5.67% levels. The one-over-five spread was flat at 180bps levels. The OIS curve will take its cue from government bond yield movements.

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