Comment

The bond market is adjusting to lower yields. That adjustment is resulting in the yield curve going all over the place, with inversion at the five-over-ten segment of the curve and steepening at the ten-over-thirty segment.

The five-over-ten segment of the curve has inverted from 8 basis points to 17 basis points (bps) week on week, while the ten-over-thirty segment has steepened by 10 bps to 111 bps. The volumes are also concentrated on three bonds, the 8.24% 2018 bond, the 7.56% 2014 bond and the 7.95% 2032 bond. These three accounted for over 70% of the total traded volumes last week.

The shape of the yield curve and the distribution of volumes suggest that the market is not fully comfortable with the pace of decline in yields.

The 10-year benchmark bond yield has fallen 200 bps in just under two months and is trading at multi-year lows of 5.6%. The steep decline in yields has been due to the change in policy stance of the Reserve Bank of India, from maintaining price stability to
targeting economic growth.

The pace of decline is due to the lack of exposure by the market to interest rates in a declining interest rate environment.

Interest rates had been structurally moving higher over the last four years, as economic growth was accompanied by higher inflation expectations and the market was short interest rates.

The market will have to get comfortable with lower levels of yield before the yield curve regains its normal upward sloping shape and trading becomes broad based.

The environment for bond yields to trend down is conducive, with inflation looking to print at below 1% levels in calendar 2009 (Inflation as measured by the Wholesale Price Index came in at 6.61% for the week ended December 13), economic growth coming off sharply (Index of Industrial Production growth numbers printed negative for October 2008) and commodity prices ruling at multi-year lows (oil closed last week at $37/bbl).

RBI is expected to adopt an aggressive monetary easing stance to sustain economic growth, which means reducing policy rates to all-time low levels.

The market is at present facing Rs 35,000 crore of fresh supply of gilts as part of the enhanced government borrowing programme for fiscal 2008-09.

The market is also jittery on the war posturing by the governments of India and Pakistan. The fresh supply, coupled with fears of war, has resulted in the skewed shape of the yield curve. The curve will get back its shape as supply gets absorbed and war fears die down.

Liquidity, as measured by bids for reverse repo/ repo in the Liquidity Adjustment Facility, was in surplus last week.

Bids for reverse repo at 5% touched Rs 24,000 crore. Overnight rates were trading in a 5-6.2% range. Liquidity is likely to remain easy with some tightness seen this week on quarter-end demand for funds by the banks. Overnight rates are expected to be in the 5-6.5% band.

Government bonds
Government bonds saw yields move up week-on-week. The benchmark 10-year bond yield closed the week higher by 8 bps, with the 8.24% 2018 bond closing at 5.60% levels.

The benchmark five-year security, the 7.56% 2014 note, closed up 13 bps week on week at 5.77% levels. The long bond 7.95% 2032 yield moved up 14 bps week on week to close at 6.71% levels.

RBI is conducting a Rs 10,000 crore buyback of bonds issued under the market stabilisation scheme this week. It will buy back Rs 5,000 crore of the 5.87% 2010 bond and Rs 5,000 crore of the 7.55% 2010 bond.

Cut-offs for both bonds are expected to come in below 5%, against the previous buyback cut-offs of 5.12% and 5.49%, respectively.

The RBI is also auctioning Rs 10,000 crore of government bonds this week. The bonds to be auctioned are the 7.46% 2017 bond for Rs 6,000 crore and the 7.40% 2035 bond for Rs 4,000 crore. The auction is as per the schedule given in the auction calendar for December-March 2008-09. These are off-the-run bonds and the market will price in a good illiquidity discount.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were lower in the auction last week, with the cut-off on the 91 day T-bill auction held on December 24 coming in at 5.04%, against a cut-off of 5.45% in the previous week.

The 182 day T-bill auction saw the cut-off coming in at 5.10% against a cut off of 5.61% in the previous auction. This week, RBI is auctioning Rs 500 crore of 91-day T-bills and Rs 1,000 crore of 364 day T-bills under regular auction.

Corporate bonds saw primary activity at spreads of 280-300 bps. The State Bank of India placed 10-year bonds at 8.40%, while the Indian Railway Finance Corp placed 10-year bonds at 8.63%. Nationalised banks were in the market for one year certificate of deposits at 8.50-8.75%. The one-year paper supply from banks drove up corporate bond yields at the short end of the curve, with three-year Reliance bond yields moving up 15 bps week-on-week.

Corporate bonds are likely to see good activity this week on the back of demand from provident funds who will receive Rs 10,000 crore as interest payment on the Special

Deposit Scheme
Overnight Index Swaps (OIS) saw the curve move up on profit-taking. The one year OIS yield moved up 7 bps to close at 4.67% levels, while the five-year OIS yield closed up 10 bps at 4.88% levels. The one-over-five spread steepened by 3 bps to close at 21 bps levels. The OIS curve will take its cue from government bond movements this week.

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