The Hindu Business Line : Inflation, liquidity concerns hit bonds

The US Federal Reserve hiked rates by 25 basis points, on May 3, along expected lines. But, the unexpected hike was in US discount rate (The rate at which member banks may borrow short-term funds directly from a Federal Reserve bank.) by another 25 basis points. This hike brought both the discount and the Fed Funds rate in alignment at 3 per cent.

Hedge funds' exit: What also pushed up yields was the exit from domestic equity markets by hedge funds. Some of these funds had earlier resorted to picking up participatory notes (PNs).

(PNs are unsecured liabilities raised by foreign institutional investors to facilitate participation of unregistered entities to invest in Indian equities).

These funds have begun encashing their PNs in droves and fleeing Indian and Asian equity markets. Traders said that their flight was more to commodities, in particular crude oil. Bankers said that the trigger for the flight to commodities was partially driven by speculation of a possible conflict in the Gulf region, involving Iran.

These fears prompted a hardening of the 91-day Treasury bill yield. The cut-off yield for the 91-day T-bill was 5.20 per cent, as against previous week's 5.11 per cent.

Similarly, at the 182-day T-bill auction, the cut-off yield was 5.33 per cent, up from the previous auction's 5.29 per cent.

Traders said that what also led to the slight hardening was the twin mop-up of Rs 8,000 crore through reissue the 7.55 per cent 2010 paper and the 7.50 per cent 2034 paper.

For placing these papers, the RBI had offered underwriting fee of 13 paise and 25 paise per Rs 100 respectively. Even after offering such a high fee, the papers were placed at yields of 6.99 per cent and 7.98 per cent respectively.

However, this placement and the mop-up of Rs 4,000 crore failed to reflect in the weekly reverse repo auctions.

The mop-up through the reverse repo auctions continued to be in the region of about Rs 27,000 crore.

Spreads for banks: Many banks still see good spreads in the current reverse repo rates at 5 per cent. Most of them are already earning a spread of at least one per cent through the reverse repo.

This high liquidity at the short-end notwithstanding, the 10-year yield to maturity (YTM) remained almost steady at 7.28 per cent on a weighted average basis.

The previous week, the 10-year YTM was 7.29 per cent on a weighted average basis.

Life insurers' buying: What prevented a steep fall in yields was the intervention of life insurance companies. Insurance companies were large buyers throughout last week. They picked up some of the high-coupon securities such as the 11.50 per cent 2015 and the 10.79 per cent 2015.

The 11.50 per cent coupon was picked up at an YTM of 7.3 per cent and the 10.79 per cent coupon at 7.60 per cent. Both these securities were picked up from small private sector banks, which remained sellers.

Sentiment weak: Despite this support from insurers, the underlying sentiment was weak.

This was evident from low trading volumes and large spreads.

Daily average trading volumes were just about Rs 3,000 crore during the week. The spread between one year and 23 years was 183 basis points.

One reason for the wide spread was the low interest in long-dated securities. In this category, sellers outnumbered buyers. In fact, this drove up yields on all the securities. The large number of sellers, especially banks and some mutual funds, was also due to the fact that most of them were still derisking their investment books, attempting to push down their average maturities to the lowest possible levels.

Real yields narrow: Bankers said that the bearish trend was likely to continue for some more time.

One major factor was the impact of real yields.

Real yields remained narrow, despite the advancing inflation.

Inflation was about 5.91 per cent, and the one-year real yield was negative by at least 20 basis points, well below internationally accepted levels.

Besides, the hardening of yields was also expected partly by some outflows on the non-debt capital account.

This was particularly from FIIs, which are expected to move back into the US equity markets with the rising yields there.

One-month forward premia have already hardened to 1.96 per cent given the outflows.

Last week, there was little inflow from the current account or on the non-debt capital account to offset the outflows.

Liquidating US treasuries: India and China have already begun quietly liquidating their holdings of US treasuries, driving up dollar yields. This has pushed some of the institutional funds back to their home markets. Indications of this emerging trend were apparent from the reduction in the foreign exchange reserves that dropped by $648 million.

Credit offtake: Expectations of a bear hug in the bonds was likely despite the lean season, when credit offtake typically tends to slow down.

Not many bankers, however, are expecting a slowdown. This was partly on account of the fact that bulk of their credit offtake was driven by retail sectors.

Consequently, bankers said that credit offtake would be a pre-eminent factor in determining yields during the next few weeks, along with government borrowings. Incremental credit-deposit ratios of banks are currently running at close to 100 per cent, entirely driven by non-food credit offtake.

As a result, some hardening of corporate borrowing was expected in the coming weeks, assuming a spread of at least 100 basis points over sovereign rates. Bankers said that there was unlikely to be any change in the benchmark prime-lending rate. This was because the weighted average cost of working funds continued to be low on account of the high level of recoveries.

But, bankers have begun pushing up deposit rates to meet credit funding. This, bankers said, would result in increases in the weighted average costs and consequently lead to progressive hike in lending rates.

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