Auction devolvement confuses market

The Reserve Bank of India (RBI) unexpectedly devolved on primary dealers (PDs) a large part of the Rs 7,000-crore government bond auction held on July 11. The market had forgotten when an auction was devolved on PDs and this devolvement took the market by complete surprise.

The RBI devolved on PDs Rs 3,385 crore of the Rs 5,000 crore of 7.59%, 2016 auction at a yield of 8.29%, while the 7.50%, 2034 bond was devolved on PDs to the extent of Rs 1,895 crore of an auction size of Rs 2,000 crore at a yield of 8.75%.

The market was expecting a cut-off of 8.34% and 8.79% for the 7.59%, 2016 and 7.50%, 2034 bonds, respectively, and the devolvement was at yields that were below market expectations. 

Initial market reaction was negative as PDs were stuck with a large quantum of bonds that were perceived to have less demand. Yields on the 10-year bond jumped to 8.40% in initial trades after the devolvement while long bond saw quotes at 8.85% levels.

The market then ruminated overnight on the devolvement and chose to see it as a yield signal the next day. Soothing comments by the RBI that bonds will stabilise in the immediate future also comforted the markets. There was some investor interest in the 10-year bond, and yields came off by 6 bps from highs of 8.40% to close the week at 8.34%, which is higher than the cut-off yield of 8.29%.

The long bond did not see any sort of interest and yields rose to 8.89% in thin trades. PDs are still holding the long bonds devolved on them while they have managed to offload some of the 10-year bond to investors.

The coming week is crucial for bonds as an auction for Rs 5,000 crore is scheduled to be held between July 17 and 25. The auction comes before the monetary policy review on July 25, and the market will be on tenterhooks as the RBI is widely expected to raise rates in their review meeting.

The market is hoping for a cancellation as PDs are still stuck with the devolvement from the previous auction. If the auction is held as per schedule, PDs will be forced to offload their existing holdings at whatever price they can find in the market in order to underwrite the next auction. Yields could potentially move up by 10 to 15 bps as buyers extract their price in a one-way market on the sell side.  

Auction outflows impact liquidity: Liquidity as measured by the bids for repo/reverse in the Liquidity Adjustment Facility (LAF) auction conducted by the RBI was down last week with the daily average LAF bids accepted for reverse repo at 5.75%  at Rs 47,025 crore against  Rs 61,781 crore the earlier week There were no bids for repo at 6.75% last week.

The last day of the week saw the RBI sucking out Rs 39,685 crore from the system by accepting reverse repo bids in the LAF. Daily weighted average call money rates were flat at 5.80% levels, while repo levels were wide from lows of 5.50% to highs of 5.80%. 

The devolvement last week of Rs 7,000 crore government bond auction on PDs led to the fall in liquidity as PDs were forced to borrow from the market to fund their positions. The liquidity should stabilise once PDs offload their positions.

Govt securities: Government bond prices closed sharply down last week as a large part of the government bond auction was devolved on PDs. The benchmark 10-year bond, 7.59%, 2016 closed last week at 8.34% levels, up 13 bps week-on- week, while the long bond, 7.40%, 2035, closed at 8.89% levels from 8.70% levels.

The benchmark 5-year bond 9.39%, 2011 bond closed the week at 7.86% levels, up 11 bps week-on-week. The well traded 7.94%, 2021 bond saw yields going up by 11 bps week-on-week, from 8.55% to 8.66% week-on- week.

Government bonds had seen large falls during the week as the markets worried on the devolvement, but later recovered by 3 to 6 bps across the curve as the market saw the devolvement as a rate signal by the RBI. The 10-year bond had touched highs of 8.40%, soon after the auction results were announced.

Volumes were higher in the bond market last week with daily volumes in the government bond market averaging Rs 1,824  crore against Rs 569 crore the previous week. Inflation as measured by the changes in the Wholesale Price Index (WPI) came in below market expectations for the week-ended July 1, 2006. Inflation came in at 4.96% against market expectations of 5.17%.

The coming week should see the market on tenterhooks. The market is sitting heavy due to the devolvement of the last auction on PDs. Announcement of a scheduled auction of Rs 5,000 crore of a 15-19 year maturity paper will force PDs to offload exisiting positions in order to underwrite the fresh auction.

The spike in oil prices with brent crude crossing $77/bbl due to tensions in the Middle East will also play on the markets minds. Repercussions of the Mumbai blasts on stocks and foreign fund flows are also negative for bonds. Outlook for bonds is negative with auctions, oil prices and upcoming review of monetary policy.

Treasury bills: The 91-day Treasury-bill (T-bill) auction on July 12 saw a cut-off of 6.40% against a similar cut-off seen in the previous auction. The 182 day T-bill auction saw a cut-off of 6.74% last week, against a cut-off 6.78% seen in the previous auction.

The RBI chose to accept only Rs 525 crore, out of a totalsize of Rs 1,500 crore in the 182-day T-bill auction. T-bill yields fell post- auction with the 91-day bill trading at 6.30% levels and 182-day T-bills trading at 6.70% levels.

Corporate bonds: Corporate bond spreads were in a narrow range as yields tracked government bonds. Primary issues are likely to get postponed as demand wanes for longer dated bonds due to hazy interest rate outlook.

Overnight Index Swaps: The OIS market saw yields move up by around 5bps with the benchmark five-year OIS yields closing last week at the 7.38% levels against the 7.33% levels seen the previous week.

(The author is a portfolio manager with  Patco Investments & Consultancy Services (P) Ltd and the views expressed herein are personal. Please e-mail feedback to feedback@arjunparthasarathy.com.)