Comment

The bond market is facing a stream of headwinds for yields to sustain at current levels.
They are in the form of technicals, the scenario of monetary policy tightening, higher trending inflation expectations, high levels of government borrowing and worries of oil shock owing to tensions in the Gulf.

Ten-year benchmark bond yields, which are at 7.73% levels, would come under pressure due to these factors. There are not too many positives to counter except good liquidity and steepness of the yield curve.

However, when the yield curve direction is up it will be difficult for participants to hide in any segment of the curve.

The issue with technicals is as follows: The ten-year benchmark bond —the 6.90% 2019 — has seen yields go up to one-year highs of 7.73%. The rise was accompanied by a drop in volumes. Volumes have come off by almost 80% over the last one week.
The market is sitting on a large floating stock in 6.90% 2019 bond without any apparent exit routes.

The bond has an outstanding issuance of over Rs40,000 crores and even if half of it is lying in trading books, it is a potential disaster.

Rising yields and drop in volumes will heighten impact cost of exit and if investors do not buy this bond to take stock away from trading books, yields will rise sharply as no trader will want to touch this bond.

The reason for 6.90% 2019 bond going out of favour is the embracing of the 6.35% 2020 bond as a standby benchmark by traders. This one matures in January 2020 and will have exact ten-year maturity next month. However, if one section of the market is trading the 6.35% 2020 as the benchmark, the other is stuck with 6.90% 2019.
The spread between the two is an inverted 13 basis points with the 6.35% 2020 bond trading at 7.60% levels.

Those trading the 2020 will have to assume that the market is comfortable holding ten-year bonds at 7.60% levels, while those holding the 2019 will want to be comfortable at 7.73% levels amid dwindling volumes and negative rate factors.

RBI-Finmin meet: The meeting between Reserve Bank of India (RBI) governor and the finance minister on December 18 assumes significance with regard to monetary tightening. The market is ripe with speculation of rate hikes following the sharp rise in inflation expectations. Inflation expectations are trending higher on the back of a rise in primary articles, fuel and manufacturing prices.

Inflation as measured by the wholesale price index (WPI) for November 2009 came in at 4.78% against expectations of 4.20%.

The number for December, to be released in January, is expected to come in at over 6.5% levels, which is the year-end target of the RBI.

Inflation expectations are trending higher due to the sustained rise in primary articles’ prices and higher global commodity prices, and, in all probability, inflation, given its current trend, will far exceed RBI’s March-end target of 6.5%.

Participants are also focusing on the potential bond supply in the next fiscal. They are worried that gross borrowing may be at similar levels to this fiscal’s at Rs450,000 crores. The one-off items of the Sixth Pay Commission arrears and farm loan waivers will be compensated by higher interest outgo and redemptions.

The government will not have outstanding market stabilisation scheme (MSS) bonds or RBI purchases (if inflation is trending much higher than expectations) to cushion the supply.

What adds to the uncertainty on inflation are oil prices, which have been volatile in the past couple of months. Nymex crude touched highs of $82/barrel and fell to lows of $69 in this period. Prices have risen sharply by almost $5 on the back of tensions between Iran and Iraq. Geopolitical tensions will keep prices volatile.

Liquidity
Liquidity as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of RBI, dropped sharply from levels of Rs100,000 crores to Rs40,000 crores. Bank strikes and undercovering of product last week was largely responsible for the lower reverse repo bids.

Liquidity may remain at around Rs50,000 crores or below as advance tax of Rs55,000-60,000 crores exits the system. Overnight rates were at 3.40% levels from around 3.25% levels seen last week. Overnight rates are likely to trend higher on the back of year-end tightness in liquidity.

Government bonds
Government bonds saw bond yields close higher week on week. The ten-year benchmark 6.90% 2019 saw yields close the week at 7.71% levels, up by 13 bps.
The new five-year benchmark, the 7.32% 2014, saw yields move up by 14 bps to close at 7.24% levels. The 6.35% 2020 saw yields close up 1 bp at 7.59% levels as the market embraced it as the new ten-year benchmark, while the 8.24% 2027 bond saw yields close flat at 8.31% levels.

The government auctioned Rs9,000 crores of bonds this week. These include the 7.02% 2016 bond for Rs4,000 crores, a new 11-year floating rate bond for Rs2,000 crores and the 8.28% 2032 bond for Rs 3,000 crores.

The cut-offs came in at 7.50%, 4.87% (Rs 91) and 8.40%, respectively. The cut-off on the floater was lower than market expectations of Rs95 as the market grappled with the right price for the paper.

Treasury bills,corporate bonds and overnight index swaps
Treasury bill yields were higher in the 91-day auction held on December 16 with the cut-off on at 3.68% against 3.40% seen in the previous auction. The 364-day auction saw the cut-off coming in at 4.68% against 4.50% earlier. RBI is auctioning Rs5,000 crores of 91-day bills and Rs1,000 crores of 182-day bills this week.

Corporate bond yields were higher week on week as the short-end of the curve moved up sharply on the back of worries on liquidity and RBI policy actions.

Five-year benchmark bonds traded at 8.35% levels, up 10 bps week on week, while ten-year benchmarks traded at 8.68% levels, up 3 bps.

Five-year spreads closed lower by 15 bps at 92 bps levels, while ten-year spreads closed down 18 bps at 82 bps levels.

Spreads came off largely on the back of rise in government bond yields. Corporate bond yields are likely to remain pressured on year end liquidity issues and on rate hike worries. Overnight index swaps (OIS) saw the curve move up week on week on the back of expectations of rate hikes.

The five-year OIS yield closed up 11 bps at 6.92% levels, while the one-year OIS yield closed down 24 bps at 5.12% levels.

The one-over-five spread closed down by 12 bps at 180 bps levels. The OIS curve is likely to remain pressured with incremental paying coming in at any dips.

(Disclaimer: The writer is head-fixed income, IDFC Mutual Fund. Views are personal)