Ten-year bond cut-off likely below 7.90%

The government is commencing its borrowing programme for fiscal 2011-12 on April 8 by auctioning Rs12,000 crore of bonds of which there will be two fresh issuances and one reissuance.
The fresh issuances will set the benchmark yields for the seven- and ten-year papers. The market is starved of ‘on-the-run bonds’ and will eagerly embrace the benchmarks.

Demand will be excellent and cut-offs will come in better than expectations. The seven-year cut-off is likely to be around 7.75-7.80% levels, while the ten-year cut-off will be in the 7.85-7.90% levels.

The cut-offs will be lower by at least 10-15 basis points (bps) from current yields on similar maturity bonds given that these bonds carry illiquidity premium because they are off-the-run.

The market will shrug off rising oil prices as it brings down yields in the auction. Oil prices touched fresh multi-year highs on the back of better economic data in China and the US.

Brent crude prices closed last week at 118.70 a barrel as US manufacturing for March grew at the fastest rate is seven years, while the economy created 216,000 jobs in the month against expectations of 196,000.

Unemployment rate dipped to 8.8% from 8.9% seen in February.
China’s manufacturing grew in March for the first time in four months indicating that the tightening stance there has not hampered growth. Rising oil prices are a threat to inflation expectations, but the government is subsidising fuel prices leading to an understated inflation data.

The Reserve Bank of India (RBI) will raise policy rates to rein in inflation expectations and the markets have discounted another 50 bps rate hikes from current levels. Hence, rising oil prices will not force a market sell off or prompt lower appetite for bonds in the auctions.

Positions are light and till the market is filled with bonds, there is no threat of yields rising. Traders will first have to absorb initial supply and as cut-offs come in better than expectations on initial demand exceeding supply, bond yields will trend down.

As the market gets filled with positions at lower yields, the risks to a selloff will increase. That risk should emerge around mid-May, when the government has gone through around six auctions of ¤12,000 crore each. Until such time, participants will bring down yields rather than take them higher.

Liquidity is unlikely to cause problems in the coming months. Government spending of around ¤70,000 crore in March will be reflected in the April liquidity situation.

Banks will be flush with funds after the deposit-raising spree in the last quarter, which saw them garnering ¤170,000 crore between January 1 and March 11.

Foreign institutional investor (FII) flows are also getting back to normal with FIIs being net buyers of equity and debt in March against being net sellers in January and February.

Systemic funds, as measured by bids in the liquidity adjustment facility (LAF) auction of the RBI, will shift to positive territory with banks lending to the RBI rather than borrowing from it as they have being doing in the last eight months.

Even if banks do borrow from RBI it will be to arbitrage against liquid-fund returns (liquid schemes of mutual funds).

Money market papers have started reflecting easing liquidity situation in April. One-year certificate of deposit rates have come off by over 60bps week on week on the back of easing liquidity expectations. Yields on money market papers will ease further as positive liquidity conditions exceed market expectations.

Liquidity as measured by the bids for repo in the LAF auction of the RBI, tightened last week with daily average bids for the week at ¤93,000 crore against ¤71,000 crore seen in the week before last. The last week of the fiscal year typically sees high demand for funds from the system.

Government bond auction
There were no government bond auctions last week. The government is scheduled to auction ¤12,000 crore of bonds this week. The bonds to be auctioned are a fresh seven-year maturity bond for ¤4,000 crore, a fresh ten-year maturity bond for ¤5,000 crore and the 8.30% 2040 bond for ¤3,000 crore.