The Hindu Business Line : Selling wave in bonds on weak equities, AIG scandal

Traders said that the wave of selling was also triggered by the bear phase in the equity markets, where the foreign institutional investors were sellers partly driven by scandals in the large insurance giant American International Group.

Most of the AIG operated funds, traders said, were sellers in the Asian equity and bond markets. This prompted traders to slam stop loss triggers, leading to all-round losses. In fact, some of the traders said that even insurance companies were sellers in the bonds, as some of them stepped in to support the equity markets.

But the weakening in the bond markets failed to reflect in the weekly reverse repo auctions. At the weekend three-day repo auction, the mop-up was close to Rs 26,000 crore. This appeared to convey that markets were awash with liquidity. Traders said that this contradictory trend largely stemmed from the fact that most banks preferred to park their funds in the reverse repo window, instead of bonds. This was in view of the high liquidity of the instruments, though returns were far lower.

Still, bankers said, the 4.75 per cent reverse repo rate was preferable to parking resources in illiquid securities.

Preference for T-bills: Moreover, bankers have also shown increasing preference for treasury bills to park short-term funds on account of the high liquidity. The preferred instrument was the 91-day T-bill, where yield at last week's auction softened to 5.15 per cent. This was same at the 364-day T-bill auctions as well, where the yields held on to 5.64 per cent.

The spreads between the 91-day and the 364-day though widened to 50 basis points, indicating bankers' preference for short-dated papers.

As a result, the 10-year yield to maturity punched the 7 per cent barrier. It closed the week at a weighted average YTM of 7.08 per cent, up from the previous week's 6.99 per cent.

Thin volumes: Weak sentiment was evident from the thin trading volumes and widening inter-tenor spreads. Daily trading volumes hovered between Rs 2,000-2,600 crore during the week.

Moreover, the spreads between one year and 23 years were 153 basis points.

Traders said that this trend was expected to continue in the coming weeks as well. This was partly driven by the large government borrowings slated for the week.

The two securities, carrying coupons of 8.07 per cent 2017 and the 7.50 per cent 2034, totalled Rs 7,000 crore. That these securities were likely to face difficulties in finding takers was evident from high underwriting fees. The underwriting fees for these two securities were fixed at 25 paise per Rs 100 and 30 paise respectively, pushing up the yields well above the coupon rates.

This would imply that the effective costs for raising the borrowings would be high. Both these securities were already available in the markets and were quoted at yields of 7.10 per cent and 7.18 per cent respectively.

Both papers are hardly preferred papers among the banks, especially since most of them have moved all their long-dated papers into the held to maturity category after the one-time reprieve offered by the RBI last year.

Derisking portfolios: In fact, this year, with banks determined to continue the process of derisking their portfolios, most of them were reluctant to buy long-dated government papers and preferred papers under five years. Private sector banks preferred papers of just one year anticipating yields to harden further in the coming weeks.

One of the major factors driving this anticipation was the possibility of another hike in US Fed funds rates, when the Federal Open Market Committee meets again.

Traders said that the Fed's move was likely to impact global interest rates, since the FIIs were expected to begin to reduce their exposures in countries such as India with a concomitant impact on reserve money flows.

US Fed rate: Traders said that the Fed Funds rate was likely to be pushed up to 3 per cent from the current level of 2.75 per cent.

This expectation was evident from the sharp increase in forward premia across maturities. Short forward premia was already close to 2.75 per cent, though for six months and one year the premia was much lower.

IMD proceeds: Traders said that this was partly because, some of the India Millennium Deposits expected to mature during the next few months were likely to be retained in the country.

Moreover, these flows were in turn being buttressed by current account inward remittances, traders said. This trend was evident from the fact that despite the turmoil in the markets, foreign exchange reserves' accretions continued. Moreover, oil companies have also stopped taking forward cover in the markets.

Most of them had tied their forward covers and some of their futures contracts, when international oil prices dipped to $50 a barrel. Few have high price exposures.

Inflation: Traders said that what was also driving up yields were inflation expectations. In fact, inflation remained above 5 per cent at 5.26 per cent.

One-year yields were just 70 basis points above inflation, or a real yield of under one per cent, well below international expectations of one 1.5-2 per cent.

Further, traders said that hardening of yields would continue as most banks preferred to pitch for credit.

This was partly most of them believed that their existing holdings of securities were sufficient to support the statutory liquidity ratio of 25 per cent.

As against this, the G-Sec investment-deposit ratio, inclusive of the reserve repos, was above 44 per cent for most of the banks.

Accordingly, bankers said that they preferred to pitch for risk-weighted assets, where returns were higher.

Besides, with recovery mechanisms becoming sophisticated, bankers have shed the fear of non-performing assets.

Banks confident: Consequently, most of them now feel confident of operating on high credit-deposit ratios of close to 66 per cent on a nominal basis and over 100 per cent on an incremental basis.

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