The Hindu Business Line : Bond market in India

THE WINDS of liberalisation sweeping the bond market and attracting foreign institutional investors (who can hold 30 per cent of their portfolios in fixed income instruments) are also making it choppy with changes in interest rates caused by external factors beyond the direct control of the Government and the Reserve Bank of India (RBI).

The shallow market (there are only 17 Primary Dealers eligible to participate in auctions of government bonds) and the RBI's reluctance to give these players access to derivatives in government bonds makes this market even more vulnerable.

Based on current macro-economic indicators, one can draw a trend on where bond prices will go in the next half of 2005; beyond that it may merely be a hazardous guess. Since the government remains the largest borrower in India, the prices of its bonds also tend to drive that of corporate bonds in their respective segments.

In October 2004, when the Cash Reserve Ratio was raised by 25 basis points (from 4.75 per cent to 5 per cent) and the RBI increased the reverse repo rate by 25 basis points (to 4.75 per cent), bond yields jumped, sucking out about Rs 9,000 crore from the financial system.

Immediately, yields on the 91-day Treasury Bills rose by 140 basis points and on the 364-day T-Bill by 155 basis points compared to April 2004. The yield on the 5-year (7.55 per cent) government bond (maturing in 2010) shot up to 7.20 per cent, an unprecedented rise of 241 basis points from 4.79 per cent in April 2004.

In the same period, the yield on the 10-year benchmark shot up from 5.12 per cent to 7.32 per cent, a jump of 220 basis points. Inflation figures then published were around 7 per cent, adding to the panic in the market.

However, the credit overhang in the economy (estimated at Rs 60,000 crore at the end of 2004) brought bond yields down again in the first week of January 2005. Yields softened again as the market discovered that there were enough people wanting to put their funds out to lend.

The yields on the 5-year (7.55 per cent) 2010 bond and the (7.38 per cent) 10-year benchmark fell to 6.40 per cent and 6.65 per cent respectively in January 2005. As yields fell, bond prices rose.

Though this gave some respite to beleaguered bankers who had invested money in government bonds, uncertainty still loomed over the market, and the trends did not point to a bull run like the one in April 2004.

Portends for a bull run are normally shrinking spreads at the short end of the yield curve — in April 2004, when bond prices had peaked, the spreads between the 91-day and 364-day T-Bills were thin, barely three basis points but in January 2005, it became 42 basis points, showing that investors perceived an uncertain future. Even now, the difference is substantial — over 50 basis points — and the yield curve is quite steep.

The RBI's Monetary and Credit Policy announced at end-April raised the reverse repo rate further from 4.75 per cent to 5 per cent. It can be surmised that this was to counter expected inflationary pressures resulting out of rising international oil prices (a part of which the government has now decided to pass on to the consumer).

Though the year-on-year inflation was fairly low (at 5 per cent) when the annual Economic Survey data for 2004-05 were published, inflation figures had seen a fair amount of volatility (Figure 2), because of the shortages created by a late monsoon. This year too could see such volatility, on account of the effect of the oil price rise. Inflation figures definitely affect interest rates, and given the current macroeconomic situation, they would have a tendency to rise.

The RBI has projected an inflation rate of 5-5.5 per cent for 2005, given that the impact of rise in oil prices is yet to be felt, and the dollaris still a little wobbly, and might require the RBI to support it by purchasing dollars and selling rupees.

Immediately after the RBI's rate hike announcement, just as in November 2004, the market jumped before correcting itself on underlying fundamentals. In the government auctions held on May 3, the cut-off yield on the 5-year government bond was fixed at 6.99 per cent, which later eased to 6.94 per cent.

The 10-year benchmark yield shot up to almost 7.35 per cent on April 30, before going down (see 10-year yield curve, Figure 1). The yield on the actively traded 8.07 per cent 2017 bond, which had risen to 7.5980 per cent (a rate not seen since September 2002) immediately after the Monetary Policy announcement, closed at 7.5469 per cent on May 2.

Now, the question is whether this buoyancy in rates will last, or will it be a repetition of the October-December 2004 story. The yields on the 5-year and 10-year bonds softened to 6.82 per cent and 7.20 per cent respectively in the week after, which meant a rise in bond prices (Figure 3).

The enthusiastic response to the RBI's auction of Rs 8,000 crore worth of government paper on May 3 (both the 7.55 per cent 2010 and the 7.5 per cent 2034 bonds were over-subscribed) shows that there is indeed a lot of liquidity in the market. The total liquidity overhang on a daily basis is put at Rs 30,000 crore.

Yields of dated government bonds have fallen further after that, with insurance companies and pension funds buying dated securities, as banks cashed out to enter the loan market in the expectation of another year of growth and increased credit offtake.

The increase in money supply on account of growth in credit offtake and the RBI's continued support to the dollar will push bond prices north as banks park excess funds in government bonds, creating demand for them.

A comparison of the yield curves between May 16 and June 22 shows the flattening effect of this increased liquidity.

On the other hand, considering that the government intends to sell Rs 60,000 crore of government paper in the next six months, and the RBI is using its liquidity adjustment facility (LAF) effectively, this should get mopped up.

The rise in the Fed rate (to 3.25 per cent) will push up short-term interest rates in the US and, expectedly, make investments more attractive there.

There is an equally large camp saying that this may not happen because long-term yields in the US have failed to move up, leading to a flat yield curve there (described aptly as a `conundrum' by the Fed chief, Mr Alan Greenspan).

There is also an argument that the slowdown in the Eurozone economies is reducing investment opportunities there and the FIIs would continue to patronise emerging markets such as India.

True, but this would be more in the equity market, rather than in the bond market. Finally, though inflation reduces the inherent value of money, nominal rates of interest rise to keep pace with inflation.

All factors taken together, interest rate yields should rise moderately in the second half of 2005, in India on the back of moderate inflation and credit growth driven by the appetite of a rapidly growing economy. The slight bump in bond prices that we see now may not be sustainable despite the huge liquidity sloshing around in the economy. However, an increase in liquidity will greatly dampen the effect of a rise in rates.

Considering a 5.5 per cent inflation, and a 12.5 per cent increase in money supply (of which about 20 per cent would get invested in government bonds creating demand for bonds and pushing yields down), yields should move up by about 20 basis points by the year end taking the current ten-year benchmark yield of 6.83 per cent to above 7 per cent. Corporate bond yields would also move up, with a spread to account for credit risk.

The present bond market in India is different from that of the old times, in the sense that there are players who are out there to make money from debt instruments, rather than just invest funds in some interest-bearing government securities to fill up asset-liability `gaps'.

The modern treasury manager will have to take advantage of the small jumps in bond prices on account of policy announcements and changes in demand driven by the FIIs to make money, through the first-mover advantage.

That apart, primary dealers who are connected to banks, would be able to recoup some losses through the spread between their cost of funds (estimated at an average of around 4 per cent) and the reverse repo rate of 5 per cent, not to mention the added income that comes in from increased interest on housing and personal loans.

Pity, the RBI does not allow short-selling in government bonds. This, coupled with a forward market, would have enabled players (who agree with the above hypothesis), to sell now and buy later, whenever bond prices fall, making a profit.

(The author is a Consultant with the Financial Securities Group, Infosys Technologies Ltd. The views are personal. Feedback may be sent to raghuvir_mukherji@infosys.com)

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