The Hindu Business Line : Corporate bonds seem bargains

Overnight rates, which were hovering around 5-5.5 per cent, shot up to over 7 per cent - well above the RBI's repo rate, i.e., the rate at which the central bank supplies funds to banks as part of its Liquidity Adjustment Facility .

While the market seems to have cooled in the past few days - overnight rates are below 7 per cent - there are still worries about system liquidity. A sharp rise in the cost of short-term money will inevitably have a ratchet effect on the supply and cost of long-term funds. That could affect investor sentiment and the investment outlook and plans of the corporate sector.

It is the last thing the Government wants. The Finance Minister was constrained to ask the RBI to make available (not even sufficient but) ample liquidity.

The central bank's concerns are different. The economy is strong and growth is heading towards double digits. Excessive liquidity runs the risk of driving up prices. The RBI would rather keep the market on a tight leash. It has done little to counteract the withdrawal of liquidity because of the maturing IMD bonds and, equally important, the slowdown in Government expenditure.

In the past, the latter kept the market perennially flush with money. Add to this new issues of gilts and last year's mop up through the issue of Market Stabilisation Scheme (MSS) bonds - intended specifically to sterilise excess liquidity arising from the RBI's rupee support operations - and today's tight conditions are easily understood.

One gets the impression that the repo rate is not necessarily the central bank's target for overnight money. There is no systematic effort to inject or withdraw just enough liquidity to keep the market rate at or close to repo rate. In effect, the market is left to find its own level. Thus, there was a prolonged period in 2004-05 when call money was below the repo and banks found it more attractive to lend to the RBI than the market.

What will be Dr Y.V. Reddy's response to the Finance Minister? It is likely that the RBI will indeed try to align money rates with the repo rate.

How will this happen? Now that the Budget is out of the way, Mr Chidambaram might conceivably loosen his purse strings and ease Government spending. Funds from maturing MSS bonds will also find their way into the system. And a dose of unsterilised dollar buying will shore up reserves while boosting liquidity.

The prognosis is for a significant improvement in money market conditions in the coming months. That should particularly benefit corporate bonds, which have taken a beating in recent weeks because of their illiquidity and the difficult money market. Credit spreads are out of line with justifiable risk premiums.

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