Comment

The bond market last week reacted to the sharp rise in oil prices and to sustained high levels of inflation. Bond yields were higher across the curve with ten-year benchmark bonds yield moving up by 11 basis points (bps) week on week.

Five-year benchmark bond yield was higher by 12 bps while the longer end of the curve saw yields move up by 4 bps. The ten-year bond yield has moved higher by 24 bps over the last two weeks on concerns of oil, inflation and liquidity.

Oil prices touched all-time highs with benchmark Nymex crude prices crossing $134barrel last week. Oil prices are higher by over 30% from lows seen during this calendar. The high oil price is placing the government in a fix, as it has not passed on the impact to the end user.

Instead, the government is bearing the burden through subsidies and the issue of oil bonds. Oil marketing companies have been heavy borrowers in the market to pay for the increasing oil bill. This is causing a strain on liquidity. The high oil prices are also causing the sharp depreciation of the rupee.

Inflation as measured by WPI (wholesale price index) came in higher than market expectations for the week ended May 10, 2008. Inflation came in at 7.82% against expectations of 7.80%. The sharp revision for the figures for week ended March 15, 2008, caused concern. The inflation number was revised to 8.02% from 6.68%.
The bond market is facing issues on oil, inflation and liquidity.

The fortnight starting May 24, 2008, will see the kick in of the 25 bps cash reserve ratio (CRR) hike, which will suck out over Rs 8,000 crore from the system. The weakening equity market is seeing selling by foreign portfolio investors, adding on to demand for dollars. The market will tend to drip down unless there is some relief in the form of falling oil prices, onset of monsoons and inflation numbers starting to trend down.

Liquidity as measured by bids for reverse reporepo in the liquidity adjustment facility (LAF) of the RBI was easy last week, with bids for reverse repo at 6% crossing Rs 35,000 crore. The banks were well covered on their products, leading to excess liquidity.

Overnight rates eased from over 7% levels to under 6% levels. Liquidity is expected to be tight this week on fresh product covering by banks. Overnight rates are likely to trend higher.

Government bonds
Government bonds saw yields rise week on week. The ten-year bond yield closed higher by 11 bps, with the benchmark 8.24% 2018 closing the week at 8.04% levels. Five year benchmark bond yields were higher by 12 bps, with the 7.27% 2013 bond closing at 8.04% levels. Yields on the long bond, the 8.33% 2036, closed higher by 4 bps at 8.44% levels. The ten over thirty spread closed lower by 8 bps at 40 bps levels while the five over ten spread remained completely flat.

The government held dated bond auctions for Rs 10,000 crore on May 23. The auction was as per the schedule given in the government borrowing calendar for the first half of fiscal 2008-09. The bonds auctioned were the 8.24% 2018 for Rs 6,000 crore and the 8.28% 2032 for Rs 4,000 crore. The cut-offs came in close to market expectations. The 8.24% 2018 bond auction cut-off was 8.07% while the 8.28% 2032 bond auction cut-off was 8.52%.

There is a state loan auction for Rs 3,200 crore scheduled for this week.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher last week on liquidity worries. The cut-off on the 91-day T-bill auction on May 21 came in at 7.48% against a cut-off of 7.39% seen in the previous auction. The 364-day T-bill auction saw the cut-off coming inat 7.66% against a cut-off 7.55% seen in the previous auction. The RBI is auctioning Rs 500 crore of 91-day T-bills under regular auction and Rs 500 crore of 182-day T-bills under regular auction this week.

Corporate bonds saw yields move higher on interest rate and liquidity worries, though spreads came off as yields turned sticky at higher levels. Five-year yields were trading in the 9.53% to 9.57% range, up by 7 bps week on week. Five-year AAA bond spreads were lower by 6 bps week on week at 136 bps levels.

Overnight index swaps (OIS) saw the swap curve move up on interest rate worries. One-year OIS yields moved up by 9 bps to close last week at 7.50% levels while the five-year OIS yields closed higher by 15 bps at 7.72% levels. The one-over-five spread steepened by 6 bps week on week to close at 22 bps levels. The spread may flatten if liquidity tightens in the system and drives up overnight rates.