Budget blues for bond market likely

The Centre likely to unveil a higher borrowing programme

The bond market sold off last week as inflation and liquidity fears gripped the market. Bond yields rose 18bps week on week with the 10-year benchmark bond closing last week at 7.69% levels from 7.51% levels seen in the week earlier to last. The swap curve factored in tightening liquidity and higher overnight rates with the one over five OIS (overnight index swap) spread inverting 8bps to close the week at 21bps levels. Corporate bond yields rose with spreads widening even as government bond and swap yields rose. Corporate bonds were plagued by incessant supply from banks at the short end of the curve with one-year yields touching 10%.

Inflation as measured by the WPI (wholesale price index) came in higher than expected at 4.35% for week ended February 9, 2008. Market expected inflation to come in at 4.10% levels. Liquidity in the system tightened with bids for repo averaging over Rs 17,000 crore last week.

The sharp rise in yields is factor of over optimism by the market which was long interest rates on expectations of a softening interest rate stance by the RBI (Reserve Bank of India). However, higher trending inflation coupled with hawkish comments from the Government and the Central Bank on inflation unnerved the market. The market also had to deal with rising oil prices with Nymex crude crossing the psychological $100/bbl mark. A rising dollar also did not help inflation fears as the pair crossed Rs 40 on weak equity sentiments. The shift in interest rate expectations led the market down as longs were unwound.

Global treasury yields also rose as markets factored in higher inflation. US 10-year treasury yields rose week on week on inflation fears. The US Federal Reserve had indicated lower rates to spur an economy going into recession, but indicated inflationary pressures existed. The ECB (European Central Bank) lowered growth forecasts while raising inflation forecasts for the Eurozone.

The market also grappled with tight liquidity conditions. Higher demand for money coupled with shortage of funds led the market to access the RBI window for funds. The tightness in liquidity is attributed to lack of government spending, lower external flows, importer demand for dollar and higher credit offtake.

Corporates that were earlier accessing equity markets or external market for funds found the road blocked on weak equity markets and are now scrambling for funds in the domestic market. March is expected to be tight month for liquidity on year-end factors and advance tax outflows. This is also making the market cautious on existing liquidity and those with surplus liquidity are preferring to hoard rather than lend.

Liquidity as measured by bids for reverse repo/ repo in the LAF (liquidity adjustment facility) of the RBI saw bids for repo at 7.75% averaging Rs 17229 crore last week as liquidity tightened in the system. Overnight rates trended higher and were quoting around 7.5% levels.

Government bonds
Government bonds saw yields rise week on week. The yield on the benchmark 10-year bond 7.99% 2017 bond was higher by 18bps to close at 7.69% levels. Five-year benchmark bond yields was higher by 12bps with the yield on the 7.27% 2013 bond closing at 7.62% levels. Yields on the long bond the 8.33% 2036 bond closed higher by 18bps at 7.99% levels.  The ten over thirty spread closed flat at 30bps levels. The market is nervous and the Budget next week is not positive for bonds as the Centre may unveil a higher borrowing plans.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were higher last week. The cutoff on the 91-day T-bill auction held on February 20 came in at 7.39% against a similar cut off seen in the previous auction. The 182-day T-bill auction saw the cutoff coming in at 7.53% against a cutoff of 7.27% seen in the previous auction. The RBI is auctioning Rs 500 crore of 91- day and Rs 1,000 crore of 364-day T-bills this week.

Corporate bonds saw yields move higher across the curve on rising government bond yields. Spreads trended higher on continuous supply at the short end of the curve. One- year papers were traded at 10% levels up by 60bps week on week. Five year bonds were dealt at 9.40% levels as traders offloaded stocks. The 5-year AAA bond spreads were higher by around 10bps week on week at 161 bps levels.

Overnight Index Swaps (OIS) saw the swap curve invert sharply on liquidity concerns.  One-year OIS yields moved higher by 27bps to close last week at 7.18% levels while the five-year OIS yields closed higher by 20bps at 6.98% levels. The one over five spread inverted by 8bps to close at 21bps levels. OIS yields may remain pressured on liquidity concerns.

The author is head, portfolio management services, Sundaram BNP Paribas AMC Ltd. The views expressed by the author are his own and need not represent the views of the organisation in which he works.