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The current uncertainty facing bond markets is likely to persist in the near term, given the conflicting signals emanating from various factors.

On one hand, the market is faced with the spectre of higher supply while on the other, the high liquidity and high deposit growth in the banking system is absorbing the supply, albeit at higher levels of yields.

The government is scheduled to issue Rs 48,000 crore of bonds in June and this is likely to be increased as government finances remain under pressure on the back of lower revenues and higher expenditure.

The banking system is seeing year-on-year deposit growth of over 22% and this high deposit growth is not matched by credit growth, which is growing at around 17%.

Banks are flush with funds and are parking over Rs 2 lakh crore with the Reserve Bank of India (RBI) and mutual funds. Bank investment in government securities is not very heavy, with just over 26% of net demand and time deposits invested in government bonds. This is against the statutory level of 24% prescribed by the RBI.

Banks’ inherent demand for government bonds is met by the government with higher supply, keeping bond yields from rising too high in the face of other interest rate negative factors which include rising oil prices, high global bond yields and expectations of incipient economic recovery.

Oil prices closed last week at over $66/bbl and this is giving rise to inflation worries as well as worries on higher subsidy element of government finances.

Global bond yields closed at higher levels last week on the back of bond markets worrying about high fiscal deficits of governments and inflationary pressures on the back of central banks pumping in primary money into the system. Bond markets are also watching economic data, which is showing signs of global economies bottoming out. On the domestic front, GDP numbers for the period January-March 2009 came in at 5.8%, against market expectations of 5%. The full year GDP numbers came in at 6.7% against government estimates of 7%.

Inflation as measured by the wholesale price index (WPI) came in at 0.61%, for the week ended May 16, below market expectations of 0.69%. 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) 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 yields move up on the back of higher supply worries. The benchmark 10-year bond, the 6.05% 2019 note, saw yields move up by 21bps to close the week at 6.69% levels. The five-year benchmark — the 6.07% 2014 bond — saw yields close up 23bps at 6.30% levels, while the long bond, the 6.83% 2039 bond, saw yields close up 20bps at 7.75% levels.

The government auctioned Rs 15,000 of bonds last week. The bonds auctioned were the 7.59% 2016 bond for Rs 6,000 crore, the 7.94% 2021 bond for Rs 3,000 crore, the 8.24% 2027 bond for Rs 3,000 crore and the 7.40% 2035 bond for Rs 3,000 crore.

The cut-off came in better than market expectations for the 2016 bond at 6.94%, while cut-offs for the other bonds, respectively, were around market expectations at 7.34%, 7.70% and 7.79%.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher in last week’s auctions, with the cut-off on the 91 day T-bill auction held on May 27 coming in at 3.32% against a cut-off of 3.28% in the previous auction.

The 182-day T-bill auction saw the cut-off coming in at 3.59% against a cut-off of 3.49% in the previous auction. The RBI is auctioning Rs 4,500 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. Five-year benchmark bonds traded at 8.15% levels, up 20bps week-on-week, while 10-year benchmark bonds traded at 8.75% levels, up 10bps week-on-week. 10-year spreads closed at 195bps levels while five-year spreads closed at 160bps levels. Corporate bond yields are likely to track government bond yields this week.

Overnight index swaps (OIS) saw the curve steepen as the five-year OIS saw yields move up on the back of rise in global bond yields. The five-year OIS yield closed up 20bps at 6.23% levels while the one year OIS yield closed up 12bps at 4.03% levels. The one-over-five spread moved up 8bps to close at 220bps 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. Views are personal.