Wrong auction stock throws yield curve haywire

The choice of auction stock is important when the market is apprehensive of interest rates.

The government, by reissuing the 7.59% 2016 bond for Rs4,000 crore in last week’s bond auction, has chosen the worst stock possible in bad market conditions.

The stock had an outstanding of Rs50,000 crore and with last week’s Rs4,000 crore issuance the outstanding has gone up to Rs54,000 crore.

The maximum outstanding limit for each stock is Rs60,000 crore and from here on there can be a maximum of two more auctions for this stock.

Hence, even at the time of the auction, the stock was off the run and warranted a high illiquidity discount.

Compounding matters, inflation for March, which was released just before the submission of auction bids, came in way above market expectations and bidding interest in the 7.59% 2016 stock vanished.

The auction results saw the cut off for the 7.59% 2016 bond coming in at 8.21% with Rs875 crore devolving on to the primary dealers. The bid to cover ratio was barely over 1 with total competitive bids received at Rs5,553 crore against an auction size of Rs4,000 crore.

In comparison, the other two auction stocks, the 8.08% 2022 bond and 8.26% 2027 bond, saw good bidding interest with total bids at over two times the auction size.

The cut off of 8.21% on the 7.59% 2016 bond is against a cut off of 8.25% on the 8.08% 2022 bond and traded levels of 7.98% on the 7.80% 2021 bond.

The low demand coupled with high cut off in terms of yields implies the market’s aversion towards illiquidity, especially in the beginning of the auction calendar.

The government should take a note of this and choose auction stocks that will go well with the market. Wrong choices costs the government plenty as they have to pay higher interest costs when cut off come in at higher yield levels.

Inflation as measured by WPI (wholesale price index) for March 2011 stood at 8.98% against market expectations of 8.38% and against RBI’s forecast of 8%. Inflation data, even at higher levels, does not reflect the true inflation in the economy as fuel prices do not reveal the rise in crude oil prices. Oil prices rose by over 30% in the last four months and the government is yet to pass on the oil price burden into the economy. The government is allowing its subsidy bill to rise (currently at over Rs175,000 crore at present oil prices) and it has not budgeted for the rise in subsidy bill. Fuel subsidy for 2011-12 is budgeted at
Rs23,640 crore.

The market will start factoring in a 50 bps hike in repo and reverse repo rates during the monetary policy meet in May 2011 as the RBI has to reassert itself on the price stability front. The RBI has gone wrong in all their previous forecasts of inflation over the last one year and it has been fighting an uphill battle against rising inflation expectations.

Interest rate swap yields rose to its highest level over the last two and half years with one year OIS (overnight index swap) trading at 7.70% levels and five year OIS trading at 8.24% levels, up 19 bps and 16 bps week-on-week, respectively. The curve should flatten from current five over one spreads of 54 bps as the market starts factoring in more policy rate hikes.

Liquidity is normal despite the system borrowing from the RBI last week. Bids for repo averaged Rs25,000 crore last week against bids for reverse repo at Rs62,000 crore seen in the week previous to last.

Fresh product covering coupled with banks arbitraging between repo rate and mutual fund returns took the system liquidity into negative territory.

Government bond auction
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 7.59% 2016 bond for Rs4,000 crore, the 8.08% 2022 bond for Rs5,000 crore and the 8.26% 2027 bond for Rs3,000 crore. The cut offs came in at 8.21%, 8.25% and 8.47%, respectively. The RBI devolved Rs875 crore of 7.59% 2016 bond to the primary dealers.

The government is scheduled to auction Rs12,000 crore of bonds this week.