Comment

Few surprises are expected, so bond yields may remain around current levels

Caution will rule the bond market this week given the sharp sell-off seen last week.
Bond yields moved up by 35 basis points (bps) from lows as the market offloaded longs last week. The ten-year benchmark bond yield closed at 9.15% after touching lows of 8.80% levels during the week.

The bond had initially rallied by 20 bps on the back of a sharp fall in global oil prices and on a better-than-expected auction cut-off. The bond yield, however, failed to sustain at lower levels as the market fretted on the rally being overdone, inflation numbers and government finances. The market was also sceptical of oil prices holding on at lower prices after a steep fall. The sell-off from lower levels of yields was violent and the bond yield moved back all the way up to 9.20% levels before closing at 9.15% levels.

The current yields factor in a large part of the market worries, and the market is likely to consolidate at current levels without any sharp movements either way.
The market is going into this week with many of its fears realised.

Inflation came in higher than expectations and is headed towards 13% levels as mentioned by the Prime Minister’s Economic Advisory Committee. Inflation as measured by the Wholesale Price Index came in at 12.44%, higher than market expectations of 12.10%, for the week ended August 2.

The government has accepted the pay commission recommendations and confirmed that the net impact on its finances for fiscal 2008-09 is around Rs 15,600 crore. The government has also confirmed that extra government borrowing, over and above the budgeted borrowing, will not be resorted to for funding this payout.

Oil prices fell over 1% week-on week with Nymex crude futures closing the week at $113.8 per barrel.

The futures prices had touched highs of $116 a barrel during the week and fell sharply to below $111 a barrel before closing at around $114 per barrel.

Given all this, the bond market may not see too many more surprises at this
juncture, which is positivefor stability of yields at current levels.

The government has announced a government bond auction of Rs 6,000 crore to be held on August 22, as per the auction calendar for the first half of this fiscal. The market was nervous on the auction size and had braced itself for a higher auction amount. The announcement will thus provide relief to the market.

Liquidity, as measured by bids for reverse repo or repo in the liquidity adjustment facility, was tight last week, with bids for repo at 9% touching Rs 35,000 crore. Overnight rates hovered around repo levels of 9% on tight liquidity. Liquidity is
expected to remain tighton account of the beginning of fresh reporting fortnight
and overnight rates arelikely to remain around repo levels of 9%.

Government bonds
Government bonds saw yields move higher week on week, as the market sold off from lows. The benchmark ten-year bond yield closed the week higher by 13 bps, with the 8.24% 2018 bond closing the weekat 9.15% levels. Five-year benchmark bond yields were higher by 12 bps, with the yield on the 7.27% 2013 bond closing at 9.26% levels. Yield on the auction bond, the 7.95% 2032 bond, closed the week up by 12 bps at 9.82% levels.

The Rs 6,000 crore auction announced is for the 8.24% 2027 government bond, to be held on a uniform-price basis. The market was wary of the government increasing the size of the auction and holding it on a multiple-price basis. The auction announcement will take away the uncertainty surrounding it. Insurance companies and provident funds are expected to lap up the bonds.

Treasury bills, corporate bonds & overnight index swaps
Treasury bill (T-bill) yields were lower last week on the back of good bidding interest as the yield curve shifted down in a short lived euphoria. The cut-off on the 91-day T-bill auction held on August 13 came in at 9.15% against a cut-off of 9.23% seen in the previous auction. The 364-day T-bill auction saw the cut-off coming in at 9.29% against a cut-off of 9.56% seen in the previous auction. The RBI, this week, is auctioning Rs 3,000 crore of 91-day T-bills, all under regular auction and Rs 1,500 crore of 182-day T-bills of which Rs 500 crore is under regular auction and Rs 1,000 crore is under the Market Stabilisation Scheme.

Corporate bonds saw yields move up from lows following government bond yield movements. Ten-year AAA bond yields moved down to below 10.70% levels in the initial part of the week and then backed up to over 10.80% levels as government bond yields rose. One-year benchmark bank certificate of deposits were quoted at 11.05% levels, up by 20 bps from levels of 10.85% seen during the week. Credit spreads, as measured by spread between ten-year benchmark AAA paper and the ten-year government bond, moved down by 10 bps to close at 150 bps levels as corporate bond yields turned sticky at higher levels. Corporate bonds yields are likely to remain in a tight range, moving more on supply and liquidity issues.

Overnight index swaps (OIS) saw the curve move up sharply as government bond yields rose. The one-year OIS yield moved up by 16 bps to close last week at 9.39% levels, while five-year OIS yields closed higher by 34 bps at 9.33% levels. The one-over-five OIS spread flattened by 16 bps to close at 32 bps levels. OIS yields are likely to follow government bond yields this week.

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