The Hindu Business Line : Oil prices, inflation weigh on bond market

BONDS continued to fall for the fourth straight week as markets faced a deceleration in reserve money accretions. Traders are nervously waiting for the Union Budget. They are also looking to the rate hike decision of the US Federal Reserve, which meets on June 29-30.

Once the announcement of a hike is known, traders anticipate a similar interest rate tightening worldwide. The Fed chief, Mr Alan Greenspan, has already hinted at sharp increases in interest rates.

The resurgence in international oil prices also worried the market. Oil prices, which had retreated to below $40 a barrel, have jumped up. As a result of the hardening oil prices, several companies had bought oil futures for the short term to take advantage of the price drop. Domestic oil companies import about 36 per cent of their requirements from the spot markets. About 64 per cent of it was on the basis of term contracts. Even these term contracts were on the basis of prices linked to Dubai crude prices.

This means Indian oil industry was vulnerable to price increases. Consequently, fear of spikes in prices and exchange rate depreciation pushed companies to hedge exchange rates at low forward premia. This affects the bond markets as well, resulting in yield spikes. This took place to some extent last week, traders said.

Along with these factors, selling by foreign institutional investors also continued unabated. FII selling in anticipation of the US interest rate hike also contributed to the hardening of yields. FII demand for foreign exchange ensured the forwards remained at a premium. Most FIIs have taken short-term forward cover, particularly for one month. This kind of trend by both FIIs and oil companies resulted in the one-month forward premium being higher than the one year.

One-month forwards were 0.5per cent last week, whereas one month was about 0.3 per cent.

LIC sold some of their holdings of government securities to bolster their equity portfolios. FIIs' slow and steady exit from the market led to a deceleration in the accretion to reserve money.

For the whole of last year, reserve money drivers were mostly foreign exchange flows into the market. Purchases of foreign currency by the RBI through sterilisation have substantially slowed down. As a result, liquidity was beginning to tighten. Tightening liquidity was evident from last week's 7-day repo auction, where the amount mopped up was less than Rs 8,500 crore. Besides, the outstanding amount on the 7-day auctions was also closer to Rs 50,000 crore, a sharp fall from Rs 75,000 crore earlier this financial year when market stabilisation was introduced.

Besides, at the treasury bill auctions, cut-off yields also hardened. The weighted average yield on the 91-day bill was 4.46 per cent, the same as the cut-off yields. In the case of 364-day, the weighted average yield was higher than the cut-off yield. The weighted average yield was 4.5 per cent, whereas the cut-off yield was 4.48 per cent. Bankers believe the interest rates were likely to remain stable in the short term or at least till such time of the Budget.

This anticipation was evident from the movement of the 10-year yield to maturity (YTM).

The 10-year YTM ended last week at 5.33 per cent on a weighted average basis, up from the previous week's 5.29 per cent.

The market undertone and outlook continued to remain weak. This was evident from the thin trading volumes, which averaged about Rs 3,200 crore daily during the week. What also reinforced the bond market's weakness was the rising inter-tenor spreads.

Spreads between one year and 24 years were closer to 170 basis points, up 10 basis points from last week. A rising differential clearly indicated that sellers outnumbered buyers. In fact, there were large number of sellers even in high coupon securities. Among the securities, that had disappeared from the market, and were now making a reappearance included the 11.83 per cent 2014. What was also worrying bankers was the rising inflation. The rising inflation was likely to bring pressure on yields. This was because real yields up to 10 years were just 0.5 per cent above inflation. The pressure on domestic yields was the slowdown in the current account and non-debt capital account flows. Most exporters, bankers said, had stopped taking forward cover. Instead, several of them were deferring their receipts.

Non-repatriable non-resident deposits have also considerably slowed down, along with the FDI flows.

The actual per day inflows was less than $50 million Higher interest rate expectations also reflected in the rising corporate spreads. Spreads between sovereigns and top rated corporate papers were about 65 basis points for public sector and 110 basis points for private sector papers. In the case of State Government papers, it was even higher. For instance, some States have offered seven-year placements with coupons of up to 8 per cent. The regime of front end discounting is slowly making a come back by most State-owned utilities in their desperation to raise funds. Front-end discounts raise the effective yields.

This was done by pricing the bonds below the face value whereas the redemption was at face value.

There are still no takers even with this kind of pricing.