The Hindu Business Line : Premium-flush insurers turn big buyers

BONDS continued their untrammelled rally as traders speculated on a possible reduction in interest rates despite the Reserve Bank of India's aggressive interventions in the financial markets.

Traders said that the rally was fomented by increased flow of liquidity. The liquidity flows more than offset the RBI's mopping up operations through its new armoury of instruments, that included the market stabilisation scheme (MSS). The mop-up was done through multiple instruments - - 7-day repurchase operations, 91-day T-bill auctions for Rs 2,000 crore and the placement of one-year securities. The repurchase operations were all done at the current repo rate of 4.5 per cent.

However, in the 91-day auctions,the cut-off rate at 4.37, was below the repo rate. The weighted average bid rate was even lower at 4.34 per cent.

The auction yield on the one-year MSS bond - 6.18 per cent 2005, on the other hand, was pushed to 4.60 per cent. However, traders said that the higher yield on the one-year bond was partly on account of the siphoning of liquidity through 7-day repos. The outstanding amount with the RBI through the 7-day repo auction was close to Rs 69,000 crore.

But despite the mop up operations, there were no bids in the reverse repo auction of the RBI. The RBI's reverse repo auctions are intended to provide liquidity to the market. Traders said that there was no demand for liquidity from the RBI window, since call rates were even lower than the repo rates.

The RBI's interventions, they said, clearly conveyed that rates were unlikely to be allowed to drop in the near term. Most traders believe that any repo rate drop was unlikely in the near future, particularly in view of the elections. The interventions in the market tempered the drop in the 10-year yield to maturity (YTM).

The 10-year YTM dropped only one basis point last week to 5.12 per cent on a weighted average basis.However, the undertone in the markets remained firm.

Trading volumes averaged about Rs 7,500 crore daily during the week. Further, the spread between the one-year and the 24-year security continued to remain narrow at about 125-130 basis points. Repo rates were acting as a floor at the short end of the yield curve.

Consequently, most of the yield softening was taking place at the long end of the yield curve, implying a flattening of the yield curve, particularly at the middle and long ends.

Trade volumes were the highest at the long end of the yield.

Trading volume in 2017 category securities, particularly 7.46 per cent 2017 overshot the Rs 1,000 crore mark. This was the first time that trade in any security was crossing this mark in more than three decades.

Buying was dominated by life insurance companies who have seen large accretions in premiums. Most of them appear to have taken the view that yields were likely to soften further. Interventions, they said, would at best defer the softening in the short term.

This was because liquidity build-up was continuing. Along with the foreign exchange reserves expansion, the build-up was coming in the capital account, in particular non-resident deposits. NRIs were converting their maturing deposits in the non-repatriable rupee deposits. But current account-driven sources also continued to expand. Besides, non-debt capital account, in particular FDI flows, has also begun to accelerate. The inflows come particularly from the merchandise trade account, where exporters have begun repatriating their proceeds.

The inflows were evident from the accretions to the foreign exchange reserves, which are now over $112 billion, propelled by an inflow of over $1 billion in a week. That the inflows would continue were evident from the falling premiums. In fact, forward premium curve has become inverted. It is 1.6 per cent for one month, whereas for 12 months, it was under 0.5 per cent.

One of the major factors for this kind of premium behaviour was in view of the fact, that some of the exporters have already taken cover at the long end, in anticipation of a rupee strengthening.

At the short-end however, there was covering by oil importers, in view of a dip in the oil prices. Oil prices have come down to about $33 per barrel despite the worsening conflict situation in Iraq and shortfalls in production there.

The shortfalls have been partly been offset by higher production by non-oil producers.

At this stage some of the oil importers have taken cover to lock into the dropped prices, since most of them expect prices to harden.

But above all there is a major shift from the dollar to the domestic currency, partly in view of the difference in inflation expectation.

Bankers said that more than interest rates what was driving forward premiums and interest rates were inflation differentials. Inflation in the US is expected to rise in view of the dollar depreciation and the worsening fiscal situation there. That inflationary spiral in the dollar was becoming evident from the record high fuel prices in the US.

On the other hand, inflation expectations within the country are bullish, and is expected to punch the 4 per cent mark.

It is at this stage that traders expect changes in the repo rate. But most traders said that there was unlikely to be any announcement. Instead, the auction yields would be allowed to drop.

But some of the banks have already discounted the softening rates and have begun realigning their lending rates, without actually dropping the prime-lending rate.

In fact, for several categories of borrowers, the lending rates are much closer to the PLR unlike in the past.

What was also bullish for the market was the Supreme Court judgement on the Securitisation Act. This judgement was expected to help bring down the weighted average cost of working funds for most banks below the 5 per cent mark.

For corporate borrowers, the softening has already begun. Most corporates are now in a position to raise funds, term funds, at sub-PLR rates, sometimes as low as 7 per cent.

Bankers estimate that the SC judgement is likely to improve the credit offtake, which has been on the rise during the last few weeks. Non-food credit offtake last week was Rs 37,720 crore, a level that has been reached after a very long time.

Credit deposit ratios are already at 57 per cent and on an incremental basis it was up wards of 75 per cent. Corporate bond spreads are also barely about 50 to 100 basis points over the sovereign lending rates.

But the worry was now clearly over State Government-guaranteed securities. Some of the banks have quietly begun making provisions for such bad assets. Banks are also attempting to capitalise on treatment of the State securities as bad assets.

The advantage in this treatment allowed them to claim tax exemptions. Yield spreads on these securities are continuing to widen.

The spreads are widening partly because, sovereign yields have dropped, though State yields have not followed this trend, partly in view of the high risk perception.