Comment

The bond market exhibited classical bullish behaviour with yields rallying across the board and the curve flattening as traders bought into the long-end of the curve to capture the fall in yields. The 10- and 30-year bonds rallied week on week by 13bps and 18bps respectively and the ten over thirty spread flattened by 5bps to close the week at around 30bps.

The market volumes were heavy, indicating healthy trader interest. The government bond auction held last week saw good bidding interest across participant segments, and the long bond saw the cutoff price coming in at Rs 0.40 above market expectations. The last trading day of the week saw some profit taking at higher levels with the ten year yield closing 4bps off lows.

The market reacted to data of RBI ( Reserve Bank of India) selling bonds and expectations ofMSS (Market Stabilisation Scheme) bond issuance. The RBI has announced auction of Rs 4,000 crore of dated bonds and Rs 5,000 crore of Treasury Bills under MSS for this week.

The market will choose to look at overnight fall in US treasury yields on the back of increasing signs of US economic recession and higher probability of the US Federal Reserve (Fed) cutting benchmark rates by 50bps in their January meet.

The other helpful data for the market is the lower industrial production numbers (The index grew at 5.3% in November 2007 against 15.8% growth seen in November 2006), falling crude prices (Nymex crude has fallen 7% from highs of $100/bbl) and fall in global equity prices (Major benchmark indices closed lower week on week on recession fears). The rally is set to continue unless there is extremely negative news on the interest rate front that could force traders to unwind their positions.

Inflation as measured by the WPI (Wholesale Price Index)came in lower than expected at 3.50% for week endedDecember 29, 2007. Market expected inflation to come in at 3.53% levels.

Liquidity as measured by bids for reverse repo/ repo in the LAF (Liquidity Adjustment Facility) of the RBI (Reserve Bank of India) saw bids for reverse repo at 6% averaging Rs 13,000 crore last week against Rs 16,500 crores in the week earlier to last.

Overnight rates hovered around 6% on good liquidity. Liquidity is expected to be easy this week though there could be pressure if equity markets fall prompting foreign investors to pull out money from the country. The large equity issue of Reliance Power is also expected to generate demand for funds that could affect liquidity.

Government bonds
Government bonds saw yields fall across the curve. The yield on the benchmark 10-year bond 7.99% 2017 bond was lower by 13bps to close at 7.57% levels. Five-year benchmark bond yields was down 3bps with the yield on the 7.27% 2013 bond closing at 7.53% levels. Yields on the long bond the 8.33% 2036 bond closed lower by 18bps at 7.88% levels.

The government bond auction of 7.99% 2017 bond and 8.33% 2036 bond for Rs 6000 crore and Rs 4000 crore held last week saw the cut off for the long bond coming in above market expectations. The cutoff for 8.33% 2036 bond came in at Rs 104.90 against expectation of Rs 104.50. The cut off on the 7.99% 2017 bond came in at Rs 102.91 against expectations of Rs 102.98.

The RBI is auctioning Rs 4,000 crore of dated bonds under the MSS program on January 17. The bond to be auctioned is the 11.30% 2010 bond for Rs 4,000 crore. The auction will help flatten the yield curve as short-end rates are pulled up on liquidity-sucking measures by the RBI.

Treasury bills,corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were flat last week on increased size of issuances. The cutoff on the 91-day T-bill auction held on January 9 came inat 7.02% against similar cutoff seen in the previous auction.

The 182 day T-bill auction saw the cutoff coming in at 7.23% against 7.60% cut off seen in the previous auction. The RBI is auctioning Rs 3,500 crore of 91-day and Rs 3,000 crore of 364 day T-bills this week including Rs 3,000 crore of 91-day and Rs 2000 crore of 364-day T-bills under MSS.

Corporate bonds saw five-year benchmark bonds yields move lower week on week. The five-year AAA bonds were quoting at 8.95% levels, lower by around by 5bps week on week.

The five-year AAA spreads closed flat at around 128bps levels. Credit spreads are unlikely to come off given the supply pressures and global rise in credit spreads.

Credit spreads as measured by default swap spreads on investment grade rated issuers have risen almost 50bps over the week implying rising cost of borrowing for corporates in the global market.

The increase in cost of borrowing is expected to feed into the domestic markets, as corporates come in and borrow aggressively to fund their expansion and working capital requirements.

Overnight Index Swaps (OIS) saw the swap curve move lower on the back of a healthy bond rally. One year OIS yields fell by13bps to close last week at 6.80% levels while the five-year OIS yields closed lower by 5bps at 6.78% levels. The one over five spread closed at negative 2bps from negative 10bps seen in the week earlier to last. The curve could invert further if liquidity get tighter on account of MSS issuances and RBI liquidity-sucking intentions.

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