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Monday, Aug 16, 2004

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Weak trend in bond market continues

C. Shivkumar

BOND prices continued to plummet as worries over inflation mounted in the financial markets along with the hardening of oil prices in the global market.

Traders said the slowdown in the foreign currency flows was having a toll on the bond markets. Besides, bunching of Government borrowings and the seven-day repurchase operations stifled liquidity.

The effect was evident when the 11-year floating rate bond issue devolved on the RBI even at a spread of 50 basis points over the 364-day Treasury bill yields. The fixed coupon issue, however, managed to push through, since the yields fixed were 7.5 per cent. This was in line with market expectations. However, the actual cost on these issues was higher, since the underwriting commissions were liberal. The underwriting commission in the case of the fixed rate bond was 10 paise per Rs 100 and in the case of the floating rate bond, 4 paise.

Tight liquidity

Tight liquidity was also evident from the 91-day Treasury bill auctions that saw less than enthusiastic market participation. The notified amount was Rs 2,000 crore, both under the normal mop-up and Rs 1,500 crore under the market stabilisation scheme. However, the bids were only about Rs 1,100 crore, at a weighted average yield of 5 per cent. The yields were well above the previous week's auction rates of 4.51 per cent.

Tightening liquidity was also evident in the call money markets, when rates that had ruled below the repo levels hardened during the week to touch a high of 6 per cent. It was at this stage that some banks tapped the reverse repo window of the RBI.Tightening was also due to temporary mismatches, among the banks, partly due to the 7-day repos. As a result, the RBI has now come back with the one-day repos. This partly addressed the liquidity tightening.

Repo rate hike?

Traders were anticipating a repo rate hike in the coming weeks. This was partly because of the high 91-day yields. Besides, some of the RBI's counterparts also have higher repo rates. For instance, the current repo rate of Bank of England is 4.75 per cent. Inflation in the UK is 2 per cent against 7.61 per cent here.

As a result of these expectations on repo rate hike, 10-year yields went over the psychological barrier of 6.5 per cent to 6.64 per cent on a weighted average basis, as against the previous week's 6.30 per cent. This rise was despite reduction in the provident fund interest rates by one percentage point (100 basis points).

The undertone remained weak. This was evident from the low trading volumes.

Low volumes

Average trading volumes last week were under Rs 2,500 crore. One reason for the drop in volumes was that some of the insurers, particularly life insurers. limited their purchases since they expect the 10-year yields to rise further. Mutual funds also restricted their purchases. In fact, funds were sellers.

Insurers restricted their purchases to some of the high coupon securities. More of these high coupons have re-entered the markets. Insurers bought some of the 11.30 per cent 2010 and 12.32 per cent 2011 securities. Both were sold in large volumes to the life insurers at YTMs of 7.30 per cent and 7.16 per cent respectively. These large-scale sales of such high-coupon securities at above market yields clearly indicated mismatches in liquidity, traders said. Most of these sales were also driven by banks and funds resorting to "stop loss" strategies.

The outlook also remained weak, traders said. Last week, the 10-year yield was negative by one per cent as against the previous week's 1.2 per cent. Further, the spreads between one-year and 24 years were close to 200 basis points.

Bankers worried

Some traders believe that yields could reach 6.75 per cent in the near term. This was beginning to worry bankers, especially since most of them are already incurring losses in treasury operations. Besides, further rise in yields would imply that they would be faced with difficult second quarter results.

However, some bankers have disputed this view. Mr K.V. Hegde, General Manager (Investments) of Canara Bank said, "The banking system is under the liquidity overhang and there is no big credit pick up."

These expectations apart, the feeling was that yields were likely to rise further. This was partly because international oil prices were driving up yields.

Limited flexibility

Although some duty cuts were expected to partly neutralise the domestic inflationary impact due to oil prices, the flexibility, however was limited. Price increases would have to follow, they added. Besides, shortfalls in customs/ excise revenues would have to be offset by higher borrowings.

Since the purchase prices of domestic oil companies were linked to international prices, the foreign exchange demand remained high. Supply of foreign exchange supplies either from current account or on non-debt capital account remained slack. The RBI's intervention to meet this demand and prevent large scale weakening of the rupee was also one of the major reasons for a tightening liquidity, traders said.

Forex inflows

Last week, forex inflows were to the tune of $1.07 billion after two consecutive drops and were partly on account of profits from these international treasury operations.

Exporters continued to hold back remittances in anticipation of a further weakening of the rupee.

But none of the large oil companies, traders said, had resorted to taking forward cover beyond three months.

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