Is Bond Street freaking out?

Record government borrowing is toying with Bond St’s psyche.

While that’s turning yields quirky, there’s also a salutary side to the story: copious liquidity means there’s still a handle on interest rates and corporates haven’t been copping it.

Public sector banks, which were gobbling up gilts in the not-too-distant past, are burping now. Yields, therefore, have been on the ascent with demand just not apace with the relentless supply.

The ten-year 6.90% 2019 bond touched a nine-month high of 7.38% on Monday before closing out at 7.34%.

Bond market participants expect the supply deluge to continue. Tag that with expectations of higher inflation and what you will see is yields rising higher, say experts.
The Reserve Bank of India will also have to step up its purchases through its open market operations (OMOs).

That’s because the central bank has purchased just Rs 41,000 crore of paper so far —- just half the target of Rs 80,000 crore set for the first half of 2009-10 ending September 30.

Sandeep Bagla, vice-president  at ICICI Securities Primary Dealership, said banks have bought enough paper between July and August.

“They have reduced buying to limit losses in a rising-yield scenario. In the next few months, the 10-year bond rising to 7.75-8% cannot be ruled out as inflation is likely to rise to 6-7%. It will also depend on how quickly the global recovery takes place,” he said.

Higher inflation is expected to force the Reserve Bank of India to hike interest rates to suck out excess liquidity from the system.

Food prices are likely to rise as the monsoon crop has been seriously affected by the deficient rains so far.

S Rajendran, general manager, treasury at Union Bank of India said trades in the last few days have not been great as the bond buying right now is more for the risky available for sale (AFS) category.

“Banks buy bonds to hold it to maturity initially. They have finished this quota and are now buying in the AFS category. AFS is not needed, it has interest rate risk attached to it,” he said.

Dealers said the RBI’s higher than expected cut-off on Friday signalled higher yields. The RBI sold Rs 12,000 crore of bonds on Friday setting the cut-off for the 6.90% 2019 at 7.30%, or 38 basis points higher than the 6.92% set on the same bond on July 24.

No surprisingly, the 10-year yield rose to close at 7.31% on Friday up from 7.18% on Thursday.

Ashutosh Khajuria, head of treasury with IDBI Bank said the dip in demand for bonds will mean the RBI will have to support the government more aggressively by buying illiquid bonds through open market operations (OMOs).

The RBI has targeted to buy back Rs 80,000 crore worth of bonds through OMOs. Khajuria said the central bank will have to be more aggressive in its bond purchases in the next one month to keep yields low because the government plans to borrow Rs 2,42,000 crore of its total Rs 4,00,000 crore in the first half ending September.

“Minimum statutory bond requirement for banks is unchanged at 24% of deposits and banks have already bought bonds worth 28% of the deposits. Incremental demand for government bonds is only likely to be 20% inline with the current deposit growth, however, government borrowing has jumped by 200% in the last one year,” he said.

Dealers are uncertain about the future because if public sector banks stop buying government paper then prices are going to fall more rapidly.

R V S Sridhar, head of markets at Axis Bank said the market is uncertain about how the huge government bond supply will be managed.

“Demand right now is insufficient to absorb the huge supply which is why the yields have reacted so much. However, having said that I don’t think yields will spike up sharply from current levels in the short term because liquidity is ample right now,” he said.