Comment

The bond market is likely to trade cautiously at current levels, with yields at three-month lows.

Ten-year benchmark bond yields at 8.35% are at levels where they are discounting inflation coming off from double digit levels, oil prices trending down to $85/barrel levels from current levels of $101/barrel and government finances improving with lower subsidies, higher tax collection and healthy proceeds from auction of 3G licences. The current levels of yields are also factoring in strengthening of the rupee from lows of 45.75. They are also indicating that there will be no cut in statutory liquidity ratio (SLR) and that off-balance-sheet bonds such as oil and fertiliser bonds will not be given SLR status.

The banking system is tight on SLR and that tightness is giving rise to a demand-supply gap, which is helping to drive down government bond yields.

The market at this juncture cannot digest any bad news on inflation, oil and government finances.

The first signs of bad news emerged when the government had to resort to ways and means advances (WMA) from the Reserve Bank of India (RBI) to fund bond redemptions. The government had not borrowed from the RBI for a while and this borrowing at a time when the government is facing a payout of around Rs 60,000 crore on account of pay revisions, fertiliser bonds and farm loan waiver raises a red flag on the state of government finances.

The inflation numbers are also coming in below expectations, indicating that they have some way to go before they cool off. Inflation as measured by the WPI (wholesale price index) came in at 12.10% for the week ended August 30, 2008, as against market expectations of 12.01%.

Oil prices have come off significantly to $100/barrel from highs of $145/barrel. However, the user is paying only $70/barrel on account of subsidies. Oil prices have to come off by another 15% and stay there for a while for the government to breathe easy.

The rupee fell to 45.75 to the dollar on account of global strength in the greenback, importer buying and weak equity market sentiments. The RBI had sold over $6 billion in July to temper the fall in the rupee. The sustained decline in the rupee will create
pressures on liquidity which is expected to be tight in September on account of advance tax outflows estimated at over Rs 30,000 crore and half-year-end demand from the banking system.

Liquidity as measured by bids for reverse repo/repo in the liquidity adjustment facility saw bids for repo at 9% ranging from Rs 1,000 crore to Rs 15,000 crore. Overnight rates hovered around repo rates of 9%. Liquidity is expected to tighten this week given auction outflows of Rs 7,000 crore, advance tax outflows of over Rs 30,000 crore and fresh product covering by banks. Overnight rates are likely to trend higher given the pressure on liquidity.

Government bonds
Government bonds saw yields move lower week-on-week, as oil prices fell. The benchmark ten-year bond yield closed lower by 13 bps, with the 8.24% 2018 bond closing at 8.35% levels. The new on the run bond, the 8.24% 2027 paper, saw yields fall 36 bps to close at 8.77% levels.

The government auctioned Rs 8,000 crore of bonds on the September 12. The bonds auctioned on a multiple prices basis were the 8.24% 2018 bond for Rs 5,000 crore and the 7.95% 2032 bond for Rs 3,000 crore. The cut-offs were around market expectations with the cut-off on the 8.24% 2018 bond coming in at 8.30% and the cut-off on the7.95% 2032 bond coming in 8.70%. The market sold off by around 5 bps after the auction as traders offloaded positions.

Treasury bills, corporate bonds and overnight index swaps (OIS)
Treasury bill (T-bill) yields were down last week with the cut-off on the 91-day T-bill auction held on September 10 coming in at 8.73% against a cut-off of 9.02% in the previous week. The 364-day T-bill auction saw the cut-off at 8.86% against a cut-off of 9.18% in the previous auction. The RBI is this week auctioning Rs 5,000 crore of 91-day T-bills and Rs 2,000 crore of 182-day T-bills under regular auction.

Corporate bonds saw yields looking to come off at the longer end of the curve while short-end yields moved higher. Ten-year benchmark AAA yields were down 10 bps at 10.85% to 10.90% levels as the market bought into higher spreads. Ten-year benchmark bond spreads are at 240 bps levels and are giving comfort to the market despite good supply. One-year benchmark bank certificate of deposits were quoted 10 bps higher at 11.30% levels on liquidity worries. The longer end will outperform the short end of the credit curve given liquidity worries.

OIS saw the curve invert further on liquidity worries. The one-over-five spread inverted by 11 bps to close last week at 68 bps levels. Five-year OIS yields moved up by 2 bps to close at 8.70% levels while one-year OIS yields closed higher by 13 bps at 9.38% levels. OIS yields will be pressured on expected liquidity tightness.

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