Comment

Liquidity is expected to stay tight

The government bond market fell following comments by the oil ministry that “oil bonds may receive SLR (statutory liquidity ratio) status”.

The benchmark 10-year bond closed last week at 7.51% levels, with yields higher by 4bps week on week. The bond had traded in a 7.45% to 7.47% band during the week and had shrugged off oil price hikes by the government and comments from the Central Bank and the Prime Minister that controlling inflation is a priority.

The market had focused on Central Bank rejecting bids in the MSS (market stabilisation scheme) auctions due to strained liquidity conditions in the system.

The oil minister’s comments took the market by surprise and prompted longs to be unwound. The market had come into last week with Rs 9,000 crore of fresh supply and was sitting long on bonds. The market is still long and without any market-moving positive news, yields are unlikely to fall from current levels.

Oil bonds are issued to oil marketing companies to compensate them for the losses incurred due to high price of crude and low price of petro products. The petro product prices are fixed by the Centre, and the government is unwilling to pass on the full extent of rise in global crude oil prices to the end user.

This causes losses to oil marketing companies and these losses are compensated by issuance of oil bonds. The oil bonds issued by the government earlier did not carry the status of SLR, and hence were illiquid and traded at high spreads of over 50bps over a SLR security even though they were risk-free in nature as they were issued by the Centre.

The government needs to issue fresh oil bonds for around Rs 40,000 crore to compensate oil companies for their losses. If crude oil prices remain high at current levels of $95/bbl, more oil bonds will have to be issued next fiscal.

The additional issue of SLR securities will add to the government borrowing programme increasing supply of bonds. The increased supply of SLR securities causes yields to rise in uncertain interest rate scenario.

Inflation as measured by the WPI (Wholesale Price Index) came in lower than expected at 4.07% for week ended on February 2, 2008. Market expected inflation to come in at 4.16% levels.

Liquidity as measured by bids for reverse repo/ repo in the LAF (liquidity adjustment facility) of the RBI saw bids for reverse repo at 6% averaging Rs 10,492 crore last week against Rs 18,702 crore in the week earlier. Overnight rates were around 6% levels.

Government bonds
Government bonds saw yields rise week on week. The yield on the benchmark 10-year bond 7.99% 2017 bond was higher by 4bps to close at 7.51% levels. Five-year benchmark bond yields was higher by 6bps with the yield on the 7.27% 2013 bond closing at 7.50% levels. Yields on the long bond the 8.33% 2036bond closed higher by 4bps at 7.81% levels. The ten overthirty spread closed flat at 30bps levels.

The government bond auction of 6.57% 2011 bond for Rs 4,000 crore under MSS saw the cutoff coming in at 7.49% against the previous week cutoff of 7.52% on the 12.25% 2010 bond. The RBI rejected bids in the MSS auction and accepted Rs 2315 crore.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were flat last week. The cutoff on the 91 day T-bill auction held on February 13 came in at 7.27% against a similar cutoff seen in the previous auction.

The RBI rejected bids in the auction, accepting Rs 1,043 crore against a notified amount of Rs 2,500 crore. The 364-day T-bill auction saw the cut off coming in at 7.48% against a cutoff of 7.49% seen in the previous auction. The RBI is auctioning Rs 500 crore of 91-day and Rs 500 crore of 182-day T-bills this week.

Corporate bonds saw yields move higher across the curve on continuous supply and waning demand. One-year yields moved higher by 20bps week on week while five-year yields were up by 10bps. The market is seeing large supply of one year papers from banks.

The banks issued papers at 9.30% to 9.40% levels. Liquidity is also tight with traditional buyers of short-end papers, the mutual funds, not being able to absorb the large supply. The high short-end yields are also pushing yields higher in the other segments of the curve.

Benchmark five-year bonds yields were quoted at 9.15% levels. The five-year AAA bond spreads were higher by around 5bps at 151 bps levels. Spreads are likely to remain pressured on continuous supply at the short end of the curve.

Overnight index swaps (OIS) saw the swap curve move higher on the back of long unwinding. One-year OIS yields moved higher by 22bps to close last week at 6.91% levels while the five year OIS yields closed higher by 14bps at 6.78% levels.

The one over five spread inverted by 8bps to close at 13bps levels. OIS yields are expected to remain pressured on weak government bond outlook.

The author is Head, Portfolio Management Services,
Sundaram BNP Paribas AMC Ltd. The views expressed by the author are his own and need not represent the views of the organisation in which he works.