The Hindu Business Line : Bonds shrug off inflation

Traders said that the signals from the Reserve Bank of India ruled out changes in the existing soft interest rate regime. Besides, they also believed that the international oil prices were likely to soften soon, and consequently halt the acceleration in inflation. But the key driver for the continuing rally in the bond markets was the reserve money expansion.

This expansion in the reserve money reflected in the dropping Treasury bill yields. Part of this expansion was addressed by the hike in the cash reserve ratio of the RBI last weekend by 50 basis points in two stages. This takes the CRR to 5 per cent by October when the peak season Credit Policy is expected. The hike would result in impounding about Rs 8,000 crore of liquidity from the markets.

However, the monetary policy intervention was anticipated by traders during the week itself, it seemed. This was evident from the slight upward movement in the 91-day Treasury bill yields to 4.66 per cent, up from the previous week's 4.63 per cent.

However, this level was considerably lower than 4.99 per cent touched on August 11.

Similarly, the ten-year yields dropped to 5.96 per cent on a weighted average basis, down from previous week's 5.99 per cent. But the ten-year yield was increasingly becoming irrelevant. This was because presently the yield was driven by two securities, the 7.37 per cent 2014 and the 6.72 per cent 2014. Moreover, another security that has come into focus during the week was the 11.83 per cent 2014. This security was traded at 6.77 per cent. Once this security was included, the weighted average YTM rose to 6.02 per cent.

Most of the trading volumes last week were concentrated at the shorter end of the yield curve and most of it below 10 years. This clearly implied that most banks were de-risking portfolios. This derisking implied shrinking the maturity of their portfolios. This was partly because, long dated securities, are treated as illiquid. This also partly explained the reasons for the trend in last week's auction. At these auctions, the 6.65 per cent 2009 security was placed at 5.89 per cent and the 8.35 per cent per cent 2022 security at 7.13 per cent. But the trend also indicated that there was virtually no interest for floating rate bonds. The 2013 floating rate bond issue devolved. The reason for the devolvement was not low subscription. In fact, the issue was oversubscribed. As against the notified amount of Rs 4,000 crore, the subscriptions were about Rs 4,500 crore. But the spreads over the benchmark were on the high side, well above the targeted ceilings. Traders indicated that most of them had quoted spreads ranging from 75 to 100 basis points above the benchmark (the six month average of the 364 day T-bill yield). This was to conform to the market expected current yield. For instance, the current yields on the 9.81 per cent 2013 per cent and the 7.27 per cent 2013 were 7.96 per cent and 6.8 per cent respectively.

As a result, at least Rs 1,250 crore of the amount devolved on the RBI and the primary dealers. Hence, more floating rate bonds are now unlikely in the near future. "Even if such issues are made in future, the spreads over the benchmark would be allowed to rise," one trader said.

Moreover, securities whose maturity profile was less than ten years, 2014 and below, had YTMs above 6 per cent. Traders said that the yield skews partly stemmed from focussed interest by some of the mutual funds and insurance companies.

In some of the high coupon securities, there was also an illiquidity premium, which kept the YTM high. Buyers for these high coupons include both banks and insurance companies. Some of the high coupons bank sold include the 10.71 per cent 2016. Some banks moved these securities into the trading/available for sale category in a bid to book profits and beef up their books for the second quarter results.

But for the fact that banks were allowed to raise the category of holdings in HTM , interest rates would have been driven up partly on account of the large provisions for depreciation. The greatest beneficiary on account of the reduced depreciation was Government borrowings during the year.

The sustainability of the low yields was however, becoming increasingly suspect. One of the major reasons stems from the widening negative real yields.

This was especially after the inflation numbers indicating an acceleration to 8.33 per cent. Secondly, the difference in the spreads continued to remain wide. The spread between one year and 24 years was over 200 basis points.

The monetary policy intervention through the CRR hike and the reduction in the interest rate in the CRR balances itself were a clear pointer to this fact.

The CRR balances would now fetch an interest of only 3.5 per cent instead of 6 per cent. This reduction was now expected to pave the way for a rise in yields and possibly a partial correction in the negative real yield situation.

Further, traders said that foreign exchange inflows into the country have again become inconsistent.

Large volumes of the inflows now taking place were on the capital account, mostly on account of the NRI deposit accounts, taking advantage of the arbitrage opportunities available. on account of the differential rates of interest rates between rupee accounts, making them volatile flows.

In fact, this was the single largest contributor for the $54 million inflows.

Current account flows, have not reached the same levels as in the past, bankers admitted.

Another factor that was also expected to drive up yields was the large increase in non-food credit.

Non-food credit last week went up by at least Rs 26,500 crore, the highest rise recorded during the year. If this tempo in non-food credit growth was maintained, the pressure on yields was inevitable, traders said.

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