Rally more likely for the bond market

The bond market may well go into April with expectations of a rally rather than a selloff. Until last week, I was of the view that bond yields will more probably rise than fall, based on the fact that fresh government bond supply coupled with high oil prices, rising inflation expectations and policy rate hikes will prompt traders to go short rather than long the market.

However, the market itself was looking for a rally and the government borrowing programme for the first half of fiscal 2011-12, has given the cue.

The market will shrug off high oil prices and policy rate hike expectations for the present and instead focus on supply absorption and market positioning.

The well-traded 8.13% 2022 saw yields fall 8 basis points (bps) last week and yields are likely to fall further this week on the back of improving sentiment.

The 8.13% 2022 and the 8.08% 2022, both of which lead market volumes, will frontrun the expected cut-off on the new benchmark
ten-year bond, which is likely to be issued in April.

Participants will look to speculate on the expected cut-off on the new ten-year bond, and will build positions in the 8.13% 2022 and the 8.08% 2022, taking their yields down.

If the cut-off expectations for the new ten-year bond is in the 7.70% to 7.80% range, yields on the well-traded papers can fall by 15-20 bps from current levels.

If the rally gains momentum, the actual cut-off yield on the new ten-year benchmark bond can come in much below 7.70% levels.

The government is scheduled to borrow a gross of Rs2,50,000 crore through the (re)issue of dated paper in the first six months of fiscal 2011-12.

Net of bond, the supply works out to Rs1,90,000 crore. April 2011 will see a supply of Rs36,000 crore with weekly auction sizes of Rs12,000 crore. May and July are the heaviest months with auction sizes of Rs48,000 crore and Rs63,000 crore, respectively, assuming that all the auctions are held on Fridays.

The rest of the months have lower supply. The supply does not seem frightening given that there is enough space in the market to absorb the supply.

Banks will be good participants in the auctions as credit off take is usually slow in April while traders will look to fill up their books given that they are short on leverage due to the weak sentiments prevailing in the markets for the last six months.

Ten-year benchmark yields have traded in a 25 bps range in the September 2010-March 2011 period indicating lack of direction in the market.

The swap market will see bond bullishness filter into swap yields. Yields on five-year overnight index swaps (OIS) are likely to come off from last week’s closing levels of 7.99%, while one-year OIS yields are likely to remain sticky at around 7.45% levels leading to a flattening of the curve.

Corporate bond yields will follow government bond yields, but with a lag.

Credit spreads will move higher as government bond yields fall faster than corporate bond yields. Five and ten-year credit spreads at 115 bps and 105 bps, respectively, will move higher by around 10 bps.

The corporate bond yield curve, which is inverted with the short-end trading at higher yields than the long end, will have to steepen first before the yields at the longer end can come off.

The government has indicated that it is running a cash surplus of Rs90,000 crore at present and will go into April with a surplus of Rs20,000 crore. So it will spend Rs70,000 crore in March, which will ease liquidity in the system.

Going into April, liquidity will ease out considerably and may even go into surplus mode from the current deficit mode.

Easing liquidity will drive down yields on money market papers, which are now trading at close to their highest levels for the year. One-year certificate of deposit rates are at 10.15% levels and this should come down by at least a 100 bps.

Liquidity as measured by the bids for repo in the liquidity adjustment facility auction of the RBI eased last week with daily average bids for the week at Rs71,000 crore against Rs1,26,000 crore seen in the week before last.

Banks, which had covered products heavily last week, saw lower demand for funds in the reporting week, leading to fall in bids for repo.

Government bond auction
There were no government bond auctions held last week.
email: arjun@arjunparthasarathy.com