Bonds prices likely to remain firm

The bond market took its cues from US Federal Reserve policy action expectations and rallied by around 8 basis points week-on-week. The rally came amidst turmoil on the domestic front with political risk increasing in the markets.

The Communist Party, which is supporting the ruling alliance from outside, is threatening to withdraw support if the nuclear deal with the US progresses further. The markets were also placed on alert on threats of global recession on the back of the US subprime fallout.

However, the recent actions of the Fed, including cutting discount rates on Fed funds and opening repo windows for asset-backed papers, sent out strong signals to the market that the Fed is there to bail out markets in distress.

Equity, currency, commodity and bond markets globally took these measures as signs that the Fed will start easing benchmark rates as early as next month. The markets rallied across geographies and asset classes, riding on the Fed cut expectations.

On the domestic front, the Reserve Bank of India (RBI) went about its normal functions as money markets were normal and RBI action was not necessary to cool the markets.

Auctions of market stabilisation scheme (MSS) bonds and government bonds went on smoothly with cut-offs coming in positive. RBI has increased the size of Treasury bill (T-bill) this week to absorb excess liquidity under MSS.

Clearly, the apex bank is observing the behaviour of domestic markets and its actions suggest that there is no threat of financial market instability on the domestic front. The low volatility in the money markets also suggested that past actions of RBI are bearing fruit.

The bond market took its cues from the rally in US treasuries, especially the two-year notes, which rallied by as much as 60 basis points on the back of Fed cut expectations. The steepening of the two over five curve also indicated strong expectations of Fed cuts. Government bonds also rallied by around 4-6 bps on the back of Fed cut expectations.

The markets, however, will take baby steps in taking yields down, as RBI is still in a liquidity tightening mode and the current market turmoil may keep it on the guard.

Political issues still exist — the recent rallies in asset markets globally may keep the Fed from cutting rates and subprime woes are still prevalent with Chinese banks now showing their exposure to the subprime market.

The battle against inflation and money supply is not over yet, as far as RBI is concerned. While headline inflation numbers are at around 4.1% (wholesale price index as of August 11) they are still looking at core inflation at over 6%.

Liquidity, as measured by bids for the reverse repo at 6% in the liquidity adjustment facility (LAF) auction conducted by RBI, trended down week-on-week. Bids came off from Rs 30,000 crore to around Rs 12,000 crore week-on-week. Overnight rates were steady at around 6% on easy liquidity conditions. Money markets may see overnight rates trending higher as liquidity falls further in the system on RBI auction of MSS bonds.

Government bonds

Government bond yields were lower week-on-week on the back of expectations of Fed cut in rates. The yield on the benchmark ten-year bond, 7.49% 2017, closed last week at 7.92% levels, lower by 4 basis points week-on-week.

Five-year benchmark bond yields were  flat with  the yield on the 7.40% 2012 bond closing at 7.85% levels. Yields on the long bond, 8.33% 2036, closed lower at 8.32% from 8.41% level.

RBI held government bond auctions under both MSS and the regular government borrowing programme last week. The 5.48% 2009 bond auction for Rs 4,000 crore under MSS saw the cut-off coming in at 7.91%, down 8 basis points week-on-week. The government bond auctions of 7.27% 2013 bond for Rs 5,000 crore and 7.99% 2017 bond for Rs 2,000 crore saw the cut-off coming in at 7.87% and 7.91%, respectively.

The cut-off on the 7.27% bond was better than expectations by around 3 basis points, while the cut-off on the 7.99% bond was lower than expectations by 1 basis point. Bonds traded lower after cut-off.

This week is light in terms of auction with only Treasury bills being auctioned under MSS, albeit a higher size. Bonds should stay firm.

T-bills, corporate bonds, OIS

T-bill yields were higher last week on the back of tightening liquidity. The cut-off on the 91-day T-bill auction held on August 22 came in at 6.81%, against a cut-off of 6.73% seen in the week prior to last. The 182-day T-bill auction saw the cut-off coming in at 7.47% against 7.27% seen in the previous auction.

RBI is auctioning Rs 3,500 crore of 91-day and Rs 2,000 crore of 364-day T-bills this week, including Rs 3,000 crore of 91-day and Rs 1,000 crore of 364-day T-bills under MSS.

Corporate bonds saw yields being pressured across the board as corporates increase their domestic borrowing due to external commercial borrowing (ECB) curbs. Three-month papers were trading at 8.20% to 8.50% levels, while one year yields were being quoted at around 9.5% levels.

Benchmark AAA spreads at 175 basis points levels were almost flat week-on-week. Credit spreads are going to trend higher as higher supply coupled with tight liquidity will push yields higher.

OIS saw yields drop on the back of Fed rate cut expectations. The curve, however, flattened week-on-week. The one-year OIS yield closed last week at 7.49% levels, down 10 basis points week-on-week.

The five-year OIS yield closed down 14 basis points at 7.56%. The one over five spread fell 4 basis points to close the week at 7 basis points levels. The curve is expected to become inverted on liquidity tightening.

The author is head, portfolio management services, Sundaram BNP Paribas AMC Ltd. The auhtor’s views are his own and need not represent the views of the organisation.