The Hindu Business Line : Yields continue northward march on inflation woes, tight liquidity

Bangalore, June 1 Bond yields continued to head north on the back of inflation worries and tightening liquidity with the exit of foreign institutional investors.

Traders said that most FIIs were exiting from the domestic equity markets, to contain damages from the sub-prime blow out back home. Instead, the blow out appeared to be spreading horizontally encompassing more American banks and financial institutions.

Hardening US rates

The spreading crisis in the US markets was evident from the hardening short-term rates in the US money markets. Six-month dollar Treasury bill yields firmed 35 basis points in one month, from 1.64 per cent to 2.01 per cent.

This was despite the liquidity injections through the Term Auction Facility (a facility that provides 28-day liquidity to American banks and foreign banks operating in the US) and support through the Treasury Securities Lending Facility (swap of eligible mortgage backed paper for US Treasuries). FIIs, as a result, consistently sold during the week.

This week alone, FII sell out was about $975 million, according to data from the Securities Exchange Board of India.

These factors, along with the high global prices, ensured that liquidity remained tight. Crude oil driven foreign exchange demand from domestic refineries is currently estimated at about $315 million per day. In addition, there are also requirements for product imports such as liquefied petroleum gas and diesel. This effectively implied a daily foreign exchange demand from the three public sector and the two private sector companies of over $500 million.

However, despite the FII sell out, the rupee appreciated. The rupee appreciated to Rs 42.59 against the greenback last weekend from Rs 42.84 the previous weekend. The appreciation was largely caused by current account inflows, both merchandise trade and invisibles, taking advantage of the favourable exchange rates. In fact, the favourable exchange rates also prompted exporters to take forward cover.

As a result, despite refineries’ presence, forward premia remained somewhat muted. One and three-month forward premia softened to 3.38 per cent (3.5) per cent and 2.44 per cent (2.8 per cent) respectively. Six and 12 months pulled back to 2.30 per cent (2.82 per cent) and 1.74 per cent (1.33 per cent) respectively as foreign direct investors covered their inward flows.

This situation, however, failed to reflect in the domestic money markets, as the dynamics changed. The liquidity overhang is slowly beginning to vaporise. The discontinuance of the market stabilisation scheme implied that liquidity would remain tight, at least for the present. At the weekly Treasury bill auction, only the normal amount was offered. At the 91-day and 182 T-bill auctions, the notified amounts were only Rs 500 crore. The cut-off and the weighted yields for the 91-day bill were 7.448 and 7.44 per cent respectively, unchanged from last week. The actual mop-up though, at the auctions, was about Rs 1,003.48 crore, in view of large non-competitive bids. The trend at the 182- day bill auction was also similar where the cut-off and weighted yields were 7.53 per cent and 7.51 per cent respectively.

The tight liquidity was also evident from the increasing recourse to the repurchase window of the RBI. The repurchase window implied liquidity support to banks and primary dealers. At the weekend three-day repo auction, the recourse to repo window was Rs 9,630 crore. The 10-year yield to maturity firmed to 8.15 per cent towards the weekend on a weighted average basis, up from the previous week’s 8.08 per cent.

Volumes increase

The tight liquidity notwithstanding volumes showed a slight improvement. But the increase in volumes, traders said was largely on account of purchases of government securities, which were not eligible for statutory liquidity ratio (SLR). The non-SLR securities included oil, fertiliser and FCI bonds. Banks have been purchasing these bonds from the oil and fertiliser companies hungry for working capital at YTMs in excess of 9 per cent. For instance, the 8.30 per cent 2023 fertiliser bond is priced at 94.10 that translated into a YTM of 9.2 per cent. Banks, traders said, have taken the opportunity to purchase oil bonds. As a result, the investment-deposit ratio of banks burgeoned. Since the beginning of the financial year, government security holdings increased to Rs 41,234 crore or double that of the corresponding period of the last financial year. The non-SLR bonds, bankers said, had now become liquid since the RBI would be conducting special market operations for oil company funding.

This was in addition to the reduction of the valuation spread by 25 basis points during the early part of the week. Besides, banks’ exposure limit to refiners with oil bonds was raised to 25 per cent of the banks capital, both tier-one and -two from 20 per cent.

Outlook bearish

The outlook was bearish for bonds. This was partly driven by high domestic inflation at 8.1 per cent.

At this level, the one-year real yield was negative by 0.45 basis points, implying that upside risks were high. Internationally, one year real yields are at least 1.5 per cent.

Traders also said that the relaxation in the external commercial borrowings policy was also unlikely to impact domestic liquidity. This was on account of the cross border liquidity crunch. Even the best rated Indian companies are currently faced with pricing pressures of spread of over 400 basis points over the London Inter Bank Offered Rate.

With such high spreads, there are few takers. The only other inflow was therefore from the current account.

Invisibles though stand mowed down by the sub-prime. That left only the merchandise trade account, which was still in the red on account of oil.

However, bankers said, one positive element in bonds outlook was credit off-take. Credit off-take remained in the negative zone, as more corporates opted for redemptions. Six weeks into financial year 2008-09, incremental credit was a negative Rs 1,838 crore and deposits Rs 28,658 crore. Besides, during the week, only about Rs 4,500 crore of inflows was expected through T-bill redemptions and coupon flows. This coincided with Government’s planned borrowings amounting to Rs 10,000 crore through placement of the 7.95 per cent 2032 and the 8.24 per cent 2018 securities.

Despite the auctions, banks are expected to make a pitch for oil bonds in view of the attractive current yields.

The switching of preferences for oil bonds though is likely to impose pricing pressures for the Government security placements in the coming months. This is especially in a situation where SLR security holdings of banks are as high as 34 per cent.

Banks are hoping that oil bonds would help overcome bottom line pressure from credit slowdown.