Corporate bond yield curve will steepen

Improving liquidity conditions bode well for the corporate bond yield curve. The AAA corporate bond yield curve is flat with 3, 5 and 10 year bonds all trading at 9.50% to 9.55% levels.

The curve will start steepening with 3 and 5 year yields falling faster than the 10 year corporate bond yields. Credit spreads are also likely to trend down as the corporate bond yield curve steepens.

Credit spreads as measured by the spread between AAA corporate bonds and the government bonds have come off on the back of improving liquidity conditions. Five and 10 year AAA spreads have come off by 10 basis points (bps) and 20 bps, respectively over the last one month to trade at 104 bps and 100 bps, respectively.

Liquidity conditions have improved considerably. Liquidity as measured by bids for repo at 7.5% in the LAF (liquidity adjustment facility) auction of the RBI has come off from a daily average deficit of Rs80,000 crore to a daily average deficit of Rs16,000 crore week on week.

Government spending, bond maturities, drop in notes in circulation, falling trade deficit and positive portfolio flows from abroad have all contributed to liquidity improving in the system. Government spending on salaries and other expenses in the beginning of every month adds liquidity into the system.

Government bond outstanding of Rs37,000 crore matured on July 2, and that money has come into the system. Notes in circulation have fallen by Rs20,000 crore over the past one month on the back of cash held by the public going into bank deposits.

Trade deficit has come down from $15 billion in May to $7.7 billion in June and this is positive for liquidity as there is less outflow of US dollars from the system.

Portfolio flows from abroad have turned positive with FII’s becoming net buyers of India equities in June and July from being net sellers in the previous months. FII’s have purchase over $2 billion of equities in June and July till date.

Corporate bond yields benefit from improving liquidity conditions as traders and investors look to lock on to the higher yields offered by corporate bonds over and above that of government bonds. Credit spreads at over 100 bps provide a cushion from interest rate volatility. Liquidity conditions are likely to stay positive keeping corporate bonds bid.

Government bond yields closed flat week on week as the market digested Rs15,000 crore of government bond auction, Rs6000 crore of cash management bill auction and Rs5250 crore of state government loan auction. The 10 year benchmark bond, the 7.80% 2021 bond, saw yields close flat week on week at 8.35%.

The bond market will await the release of IIP (index of industrial production) and inflation data, which are to be released this week for cues on direction of interest rates. The government is trying to talk down yields saying that bond yields are unacceptably high and that the government may defer some auctions till yields come off. The bond market will not buy into that statement and will look at inflation trajectory over the rest of the year in taking bond yields up or down.

US benchmark 10 year treasury yields fell 15 bps week on week, as job addition for June was lower than expected. The US added 18,000 jobs in June against expectations of 105,000 jobs. Unemployment rate went up to a 2011 high of 9.2%.

The US economy is in a sluggish growth environment. China’s inflation came in at 6.4% for June against a 5.5% rate for May. China raised interest rates by 25 bps before the release of the data. The European Central Bank (ECB) raised rates by 25 bps as a signal on vigilance on inflation, which at 2.7% levels is trending higher than the ECB target of 2%.

The US Federal Reserve will continue to maintain rates at all-time lows while the ECB is expected to raise rates a couple of more times this year. China’s inflation is seen to have peaked and there are expectations that the People’s Bank of China will put a hold on rate hikes.

Government bond auction
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 8.07% 2017 bond for Rs3000 crore, the 8.13%% 2022 bond for Rs6000 crore and the 8.28% 2027 bond for Rs3000 crore. The cut offs came in at 8.38%, 8.48%, and 8.62%, respectively. The government is scheduled to auction Rs12,000 crore of bonds this week.