The Hindu Business Line : Bond market awaits Credit Policy for direction

The reverse repo, the rate at which the RBI removes liquidity from the market, is currently at 4.5 per cent and the Bank Rate at which liquidity is infused into the market is 6 per cent.

Yet this anticipation on rates failed to show up at the 91-day Treasury bill auctions where yields plunged to 5.20 per cent last week. This fall took place despite the RBI's move to cancel auction of dated securities for Rs 5,000 crore.

Contradictory signals: The contradictory signals surprised most bond traders. This was evident from the movement in the 10- year yield to maturity (YTM). The 10-year YTM which was on the verge of moving beyond 7 per cent, reversed suddenly after the announcement and dropped to 6.71 per cent, from previous week's 6.76 per cent.

Refunds on the NTPC issue have not yet begun. This was partly responsible for the retreat.

More sops: Besides, some banks are expecting sops from the RBI for rectifying some of their losses on account of depreciation of their securities portfolios. In fact, even after the securities are transferred to the `held to maturity' category from the AFS (available for sale), most banks would still be incurring large losses. Most of them have sought amortisation of the losses in this transfer over the residual maturity of the security. Presently, under the investment guidelines prescribed by the RBI, only the premiums are allowed to be amortised in the event of a transfer to the HTM.

Banks were worried that the large losses on this transfer would have a big impact on their books. Besides, some banks are also expecting that they would be allowed to set off their depreciation against the investment fluctuation reserve, though such a step would lead to a weakening of the Tier II capital.

Undertone weak: Influenced by these factors the undertone in the market remained weak, which was apparent from the low volumes. Trading volumes last week were barely Rs 3,000 crore. However, spreads narrowed during the week. The spreads were 150 basis points, down from last week's 160 basis points. The narrowing spreads, bankers said, were prompted by large-scale sale of short-dated securities.

The yields on the 6.50 per cent 2005 security is currently at 5.51 per cent.

Insurers' purchases at the long ends of the yield curve ensured that spreads remained narrow.

Traders said that the outlook for bonds remained weak. This is because liquidity is expected to tighten in the coming weeks influenced by external factors, in particular oil prices and credit expansion.

With prices over $55 a barrel, oil companies were taking forward cover. ]

This resulted in many companies liquidating their securities holdings and sourcing foreign exchange.

Forward premia at the short end (one month to three months) were above 3 per cent and at the long end (6 and 12 months) were 2.5 per cent.

Forex reserves: Despite demand from oil companies, foreign currency reserves were rising. Forex reserves were up by $332 million to $119.636 billion for the week-ended October 15.

This was partly because some of the increases were on account of valuation changes, especially in gold and euros. Some accretions were also due to the RBI's aggressive treasury operations.

Moreover, traders said that some of the foreign exchange reserves were also being held in the form of euros. Further, most of the fund flows were on the capital account, particularly from foreign direct investment and foreign institutional investment.

However, deposits from NRIs had substantially slowed down and few banks were enthusiastic about accepting NRI deposits. The fear was that the large inflows could impact the exchange rate and dent export competitiveness.

In fact, NRIs were being encouraged to invest in equities, including the public issues either through the IPO routes or in the secondary markets.

This way, traders said, the impact on domestic liquidity was considerably lower.

Inflows on the current account, especially merchant exporters, were still being deferred, since some of them anticipate forward premia to go up further due to rising oil import bills.

Fall in yields: Further, what could also push down yields was the move by banks to sell their securities holding to bring down their high investment-deposit ratios and align it closer to the prescribed statutory liquidity ratio (SLR).

The average investment-deposit ratio for the banking sector is currently about 46 per cent and the SLR is 25 per cent.

The anxiety to sell was also driven by a possible hardening of interest rates in the coming months. A high investment-deposit ratio, in such a situation implied depreciation losses. Few banks were prepared to risk such losses.

Further, there was also the shift to core banking, where the possibility of earning spreads existed, given the pick-up in credit.

The excessive focus of the treasury incomes in the past had resulted in bringing down the yield on assets to very low levels.

This was worsened by the reduction in the interest rates on cash balances to 3.5 per cent. The low credit-deposit ratio of barely 51 per cent was also leading to a compression of spreads. Consequently, most banks were shifting to credit.

Non-food credit: Last week, non-food credit has grown by about Rs 41,000 crore, whereas food credit has shown a negative growth.

This was partly on account of prepayments by the Food Corporation of India out of export earnings from liquidation of surplus food stocks.

For corporates, this meant that borrowings were to become more expensive.

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