RBI bond purchases to push up credit spreads

The mid-quarter review of monetary policy of the Reserve Bank of India (RBI) saw the central bank announcing its intent to purchase Rs48,000 crore of government bonds from the secondary market.

The bonds will be purchased through open market operations purchase auctions, and the move is expected to add primary liquidity into the system.

The RBI is carrying out bond purchases in order to ease liquidity which has tightened due to 1) lack of government spending
2) slow growth of deposits and high credit growth 3) increase in currency in circulation and 4) third-quarter advance tax outflows.

The government is estimated to have parked Rs90,000 crore of surplus with the RBI due to slow spending.

Deposit growth of banks at 15% year-on-year and credit growth at 22% year-on-year, has seen banks draw down on liquidity.

Currency in circulation has gone up 20% year-on-year, leading to liquidity leakage from the system. Third-quarter advance tax paid in mid-December is straining liquidity.

Advance tax outflows in the region of Rs40,000 crore will not come back into the system till the government spends the money.

Liquidity

The system is drawing down around Rs120,000 crore from the RBI every day, and this will increase the as advance tax outflows hit the system this week.

RBI bond purchases of Rs48,000 crore will not nullify the liquidity.
Banks will still be strapped from cash and will continue to access the RBI for funds till the government starts spending in earnest or liquidity flows in from other sources.

Banks will continue to raise deposit rates to attract sticky liquidity as well as borrow at aggressive rates in the wholesale market.

Bank certificate of deposit rates are at 8.8% for three months and 9.5% for one year. These rates are unlikely to come down in the near future and will in fact, steadily trend higher.

Corporate bonds

Rising cost of funds for banks coupled with tight liquidity conditions will push up corporate bond rates.

Three-year AAA corporate bond rates are at 9.05% levels, while five- and ten-year AAA corporate bond rates are at 8.88% and 8.98% levels, respectively.

The curve will continue to move higher while remaining inverted. Lower rated borrowers will have to pay a hefty price for accessing the corporate bond market or for accessing bank loans given rising borrowing costs in the system.

Govt bonds
Government bond yields will remain supported on the back of RBI bond purchases and expectations that remaining bond auctions of Rs65,000 crore will get absorbed by foreign institutional investors (FIIs), provident funds and insurance companies.

FIIs will have to utilise the $5 billion of government bond limits while provident funds will need to invest Rs10,000 crore of special deposit scheme interest which will be paid out in January 2011.
Benchmark bond yields will trade in a 7.80% to 8.10% band for the next one month, given expectations of demand supply equilibrium.

Credit spreads

Credit spreads will rise on the back of government bond yields being supported by the Reserve Bank’s bond purchases and corporate bond yields rising on the back of rising cost of liquidity.

Five-year spreads at 89 basis points (bps) and 10-year spreads at 86bps will rise further from current levels and will go up to as high as 120-130bps in the coming weeks.

RBI bond purchases

The RBI purchased Rs11,706 crore of bonds last week. These included the 7.02% 2016  for Rs1,028 crore at a yield of 7.91%, the 7.99% 2017 for Rs4,797 crore at a yield of 7.95% and the 8.13% 2022 for Rs5,881 crore at a yield of 8.07%.

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