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Monday, Jun 07, 2004

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Bond markets yet to catch FM tune

C. Shivkumar

BONDS continued to slide for the fourth consecutive week as traders sold to cut losses unnerved by contradictory statements from the Government.

The Finance Minister's attempts to talk the market failed to enthuse the traders. Few traders were prepared to accept the FM's statements that the soft rate bias would continue. This was especially because the FM has so far not been able to articulate the continuance of reforms and cutting back of subsidies. This has resulted in reserve money build-up substantially slowing during the week. The slowdown in reserve money accretions was partly on account of the deceleration in the foreign currency flows.

What also contributed to driving down yields was the presence of oil companies. Several oil companies have been sourcing forward covers for their import requirements, when prices dropped below $40 a barrel. Both private and public sector companies locked into low prices and simultaneously hedged in the foreign currency markets as well.

But along with these factors, liquidity was also tightening. This was evident from the access to the reverse repurchase window during the week. This window was being accessed after a gap of more than a year. Last week, some of the banks tapped this window to raise Rs 800 crore at a bank rate of 6 per cent.

That liquidity remained tight, was evident from the high call rates. Call rates were closer to the bank rate and ranged between 6 and 6.5 per cent during most of the week. Moreover, the amount mopped up under the seven-day repos dropped to Rs 8,500 crore. This mop-up was mostly rollovers from the previous seven-day repos, traders said.

Despite the tight liquidity, both the dated securities issues went through. These issues included a 12-year borrowing and the reissue of the 6.01 per cent 2028 security. The 12-year borrowing was placed at 5.59 per cent and the 6.01 per cent security was placed at a yield to maturity of 6.23 per cent. Besides, the Government also carried out the 91-day Treasury bill auctions at a yield of 4.42 per cent.

For the dated securities auction, although both were oversubscribed, there was little participation from non-competitive bidders.

Traders expect a paring of the market stabilisation scheme. Presently, the 91-day T-bill comprised two components - Rs 500 crore by way of normal auctions, and another Rs 1,500 crore by way of the MSS. Traders said that the MSS component was now likely to be brought down in the coming weeks, if the tightening trend continued.

Signs of a tightening liquidity situation were reinforced further by the rising 10-year yields. Ten-year yields on a weighted average basis rose to 5.29 per cent, down from the previous week's 5.24 per cent.

Substantial selling was done by foreign banks and insurance companies. Foreign banks were sellers in a bid to stop losses. This accelerated the slide. The undertone was weak and volumes remained thin. Average trading volumes were only about Rs 3,500 crore. Spreads between one and 24 years remained high at 160 basis points.

Traders said that yields would fall further. One of the major reasons for this trend was partly the likely rise in the US interest rates. Presently, the 10-year US Treasury is about 4.80 per cent or about 140 basis points higher than the levels prevailed last year. Traders said that Fed funds rates, the rates at which banks and institutions lend overnight funds to each other, are one per cent. Traders said that a hike of 0.25 per cent has already been discounted.

What also worried the markets was the inflation. Inflation, as measured by the wholesale price hike was already 5.02 per cent. Consequently, real yields were low compared to international levels, where it was in the region of about 1.5-2 per cent above the inflation rate. If nominal yields were to reflect international levels, they would increase further in the coming weeks.

Traders are expecting substantial increase in Government expenditure and a rise in the public sector borrowing requirements. This was especially if cues were to be taken from the increase in subsidies by State Governments, resorted to after the recent elections.

Foreign exchange flows also eased off considerably. Up to April, the average flows were in the region of about $250 million per day. These flows presently were barely $50 million. Exporters had deferred their inward remittances, hoping to cash in on a weakening rupee and larger forward premia. Besides, non-debt capital account flows has also virtually stopped. Most of the flows were negative. Foreign institutional investors were quietly exiting. FIIs were also beginning to take forward cover for their exit. This was one of the reasons for the inversion in the forward premium curve. One month forward premium is 0.5 per cent whereas six months and 12 months are 0.26 per cent. These inversions are expected to self-correct as some of the borrowers in foreign currency also begin taking forward cover to hedge their debt service payments.

But the easing of inflows appeared to have taken the load off the Reserve Bank of India. RBI interventions for sterilisation have virtually stopped in view of the low flows.

With the liquidity beginning to dry up, corporate funding yield spreads are also beginning to rise. Yield spreads between sovereign and corporate bonds are about 100 basis points.

For instance, the 5.85 per cent 2009 HDFC bond ended the week at an yield of 5.98 per cent, 102 basis points more than sovereign security of identical maturity. This implied that borrowing costs were likely to rise further.

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