The Hindu Business Line : Bond yields fall as RBI limits intervention

Bangalore, July 8 Bond yields fell sharply last week as the Reserve Bank of India (RBI) applied the brakes on interventions with inflation remaining low.

But traders said what also helped bond prices to rise (yields to soften) were strong foreign exchange flows. The flows mostly on the capital account comprised both debt and non-debt items, inclusive of foreign portfolio investments and non-resident deposit flows. Both these items are treated as volatile components in the foreign exchange inflow basket, though they are treated as non-debt.

Despite the large inflows, the RBI limited its intervention during most part of the week. As a result, the rupee-dollar exchange rate advanced to Rs 40.46, a level that prevailed more than a decade ago.

Shrinking forward permia

The RBI’s restraint was also evident from the shrinking forward premia. One month to 12 month forward premia dropped below one per cent for the first time in several months. Six month and 12 month forward premia were below 2.5 per cent. If the present level of inflows are sustained in the coming weeks, there are distinct possibilities of the rupee going into a premium against the dollar at least at the short-end, traders said.

The flows pushed up liquidity, evident from the response to the liquidity adjustment facility (LAF) auctions towards the weekend. The combined bids at the two LAF auctions were Rs 89,125 crore, though the accepted amount was only Rs 2,999 crore.

The surfeit of liquidity ensured that weekend call rates dropped to 0.4 per cent. With the banking system awash with liquidity, the two dated security placements went off smoothly. In fact, cut-off yield to maturity (YTM) for the new 10-year security was fixed at 7.99 per cent. The reissued 8.33 per cent 2017 per cent security was placed at an YTM of 8.45 per cent.

Despite the large reserve money-led liquidity overhang, the RBI contained its market stabilisation security programme. In fact, at the 91 day-Treasury bill auctions, only the normal amount, comprising the Government’s short term borrowings of Rs 500 crore was placed. The competitive bids placed were Rs 6,246 crore, but only Rs 500 crore was accepted. But all non-competitive bids amounting to Rs 7,100 crore were accepted. The cut-off yield was fixed at 6.19 per cent and the weighted average yields were at 6.10 per cent last week, down drastically from the previous week’s level of 7.39 per cent. The T-bill yields were very close to the reverse repo rate of 6 per cent. This triggered speculation of a reduction in the reverse repo rate, if the current trend continued. At the 364-day T-Bill auctions, the trend was identical, the cut-off yields dropped to 7.17 per cent and the weighted average to 7.07.

The absence of the MSS, liquidity overhang and the cut-off fixture of 7.99 per cent pushed down the ten-year weighted average YTM to 7.98 per cent down from the previous week’s 8.21 per cent.

Trade volume low

Yet the undertone remained weak. This was apparent from the low daily trade volume of just Rs 850 crore. Besides, bid offer spreads remained high at about 12-15 basis points. Clearly any major advance anticipated in bonds would have shrunk the bid offer spreads to less than 5 basis points. The outlook appeared positive with the yield spreads rising to over 120 basis points, though this was largely due to presence of insurance companies and completion of advance tax payments. Supporting the sentiment was inflation that remained restrained at 4.13 per cent. The one-year real yield, though at 3 per cent, was double internationally acceptable levels.

Moreover, banks appeared to be building an arsenal of Government securities in anticipation of the peak season credit. The incremental investment-deposit ratio is currently 94 per cent. The interest in investments was for particularly T-bills as banks preferred to remain liquid. In fact, some traders said that this was one of the major reasons for the fall in yields at the short end, whereas at the long end, yield movements were somewhat muted.

Besides, the preference to remain derisked (keeping investment portfolios short dated) was in view of the anticipated credit off-take beginning from the peak season. Credit off- take was expected to remain high in view of the copious monsoon showers, the bankers said. At present, the incremental credit-deposit ratio was barely 10 per cent.

The nominal ratio though remained at 72 per cent. Besides, there are expectations that interventions from the RBI would resume next week onwards, in view of the sustained rise in the money supply M3, whose growth is well above the nominal GDP growth rate. Moreover, with oil prices at close to $74 a barrel, fears of resurging inflation loomed.

Inflation focus

But the inflation focus has already had an impact on the bottom lines of banks. Most major public sector banks have taken the opportunity to shift more securities to the held to maturity (HTM) category during the first quarter to cut depreciation losses. This would somewhat neutralise the impact of the drop in the yield on assets and mounting provisions on realty advances, as bad loans in the sector grow.

Banks are permitted to shift up to 25 per cent of their demand and time liabilities to HTM category. Prudent bankers have taken advantage of this clause to shore-up their first quarter balance sheets since this may very well be the last opportunity for them to undertake this exercise as the banking sector migrates to the capital regime – Basel II.

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