The Hindu Business Line : Bonds jittery over volatile forex markets

Bonds were in turmoil last week on fears triggered by volatile foreign exchange markets about the US Federal Reserve Board may be preparing to hike interest rates.

Traders said that what also lent credence to these fears were the large scale selling of dollar-denominated bonds by some of the central banks around the world. These included the Reserve Bank of India and the Chinese central bank . What also affirmed fears by most banks were statements made by the US treasury department of a potential hike in rates, to arrest the dollar's depreciation.

The expectation of a dollar interest rate hike prompted several institutional investors and foreign banks to divest from their India investments and shift to dollar-denominated securities. This was partly to take advantage of the exchange rate appreciation. What also worsened the situation in the markets was the shortage of cash dollars in the markets.

Foreign banks and investors also sold large volumes of securities during the week to convert all their investments into dollars. Besides, these banks also wanted to cut their losses in the event of a rupee slide against the dollar. These fears pushed up yields across all maturities. However, the rise in yields was tempered partly by large liquidity inflows into the market and the failure of importers including oil importers to take forward cover.

As a result, the dollar remained at a discount against the rupee, despite the weakening at the spot. The fears however failed to translate into higher yields at the short ends. Treasury bill yields continued to remain low. The mop-up during the week through T-bill auctions, both in the 91-day and the 364-day, which included both normal and under the market stabilisation scheme, was about Rs 4,000 crore.

The yield on the 91-day T-bill was 4.37 per cent and on the 364-day T-bill 4.43 per cent, well below the repo rates of 4.5 per cent. Besides, there was little impact on the repo auctions, where the outstanding are now close to about Rs 70,000 crore. Traders said that despite the weakening, what ensured a strong undertone were the thin spreads between the long and short ends. The yield spread between one year and 24 years continued to be 130 basis points. This was partly because insurers were focussed on securities between 2017 and 2022. These securities have logged the highest trading volumes during the week. Traders said that this clearly conveyed that yields were poised to fall further. The fear in the markets was that further weakening of yields was likely to push down the investment earnings of banks. Liquidity accretion from foreign sources was likely to continue. Traders said that this was partly because most of the flows were coming in the form of non-repatriable rupees, where there was little risk of outflows. In fact, it was this flow that ensured that the dollar was at a discount to the rupee for up to one year, an unprecedented situation since 1971, when the dollar was de-linked from gold.

Traders expected this situation to continue for some more time. The non-debt capital account included foreign direct investment, institutional investments and NRI deposits. The FI investments have slowed down considerably during the last few weeks, partly due to the expected hardening of US interest rates. Despite these trends, the foreign exchange reserves of the country continued to rise. Last week, it went up by $297 million to $117 billion. But traders said what could also drive up yields in the coming weeks was the rising credit deposit ratios. Treasury profits no longer appear to be sustainable in view of the flattening of the yield curve, bankers said. Some of the banks are preparing for the expansion in credit by shoring up their capital through selling their holdings of securities, when yields become favourable.

This also partly explained their eagerness to liquidate some of their bond holdings. This was evident from the incremental investment deposit (ID) ratio, which remained lower than the prescribed statutory liquidity ratio of 25 per cent.

The interest in risk-weighted assets has pushed down the spreads between sovereigns and top corporate papers to about 25-30 basis points. For some of the higher risk weighted papers, especially agriculture, small and medium enterprises, the spreads over sovereigns are about 400 to 500 basis points over sovereign or at rates closer to the prime lending rates.

These rates are not expected to change in the near future, as banks push for further increase in liquidity through securitisation. Some of the public sector banks are now in the process of preparing for securitising their retail assets on the lines of the private sector banks like the ICICI, though they prefer to wait for a far lower discounting rates.