As RBI, Bond Street spar on rates, media miss the drift

Government bond auctions are in the limelight, with media headlines screaming ‘unsold bonds’, ‘auction failure’ and ‘devolvement’.

While the first two headlines have no basis in fact, the third one, about ‘devolvement’, is both a positive and a negative.

A higher-than-budgeted borrowing of Rs53,000 crore has pushed up yields on government bonds (or their prices have fallen) in the last 15 days.

Market participants are worried about the quantum of supply looming, with weekly auctions of Rs13,000 crore to Rs15,000 crore expected over the next few months and the market’s ability to absorb this supply given the Reserve Bank of India’s (RBI) anti-inflationary stance.

As a result, the last two auctions have seen bids at higher levels in terms of yields and have also seen the RBI devolving part of the auctions on the underwriters.

This is where the headlines are going wrong.

Government bond auctions are fully underwritten by primary dealers (PDs). And how?

PDs have a minimum underwriting commitment (MUC), which is half the auction size, and an additional competitive underwriting (ACU), which is equal to the MUC. So MUC plus ACU covers the total auction size.

PDs bid for underwriting commissions for the ACU portion through a multiple price-based auction method. The RBI sets the commission based on the bids for underwriting received.

The government knows that every auction is fully underwritten and does not have to worry about them failing. The PDs look to generate bids from banks, insurance companies, mutual funds, foreign investors, provident funds, trusts, corporates and other institutions. The RBI collects the bids and, based on them, gives cut-off yields.

The auction of Rs15,000 crore of gilts on October 7 saw competitive bids of Rs27,500 crore. Where’s the question of these bonds going unsold, as reported in media? The RBI chose to ‘devolve’ or give PDs about Rs900 crore of bonds as it did not want the auction to clear at bid levels.

Again, on October 14, an auction for Rs13,000 crore of gilts saw total competitive bids at Rs26,125 crore.

Once again, the RBI chose to devolve a part of the auction on PDs as it did not want to clear at bid levels; the central bank is clearly signalling its discomfort with the high yields.

So, it’s not a question of lack of demand; it’s about bond buyers wanting higher interest rates for their money. Knowing the government needs money, they are simply trying to force the RBI to offer higher interest rates.

If the bond market takes the RBI’s cue positively, yields will go down and PDs will make money from the devolvement. On the other hand, if the market doesn’t want bonds at lower yields and the PDs are given them through devolvement, yields will rise because PDs will not be able to on-sell the bonds.

For the media, it’s important to understand this auction process before unleashing headlines.