The Hindu Business Line : Bonds back in favour after 4 years as equities dive

Most investors into bonds remain institutional, barring some high net worth individuals. Retail investors took flight from the equity markets, as foreign institutional investors divested en masse. The massive FII exodus changed the profile of the Reserve Bank of India’s sterilisation operations and liquidity in the banking system. Till last year, RBI’s open market operations implied sterilisation of excess liquidity created by reserve money supply expansion.Sterilisation of this excess money was done through reverse repurchase operations, through issuance of market stabilisation securities (MSS) and through hikes in the cash reserve ratio (CRR).

But each of these operations implied a haircut for policy makers, regulators and participants. The government costs were through interest outflows on MSS securities, though these were not treated as part of the government borrowings. The RBI took a deficit in intervention in the foreign exchange markets — through paying out 6 per cent (this is now down to 5 per cent) in reverse repurchases but earning only less than half in cross border treasury investments.

Banks’ haircut came in the form of a complete loss of interest earnings from CRR balances, even as amount impounded went up to 9 per cent in August this year. What also shrank the liquidity was non-availability of external commercial borrowings. Cross-border liquidity flows evaporated this year with FII flight and complete risk aversion by global lenders. High oil prices further compounded the situation, leading to high credit demand from refineries.

Yields above 9%

The tight liquidity situation pushed up the 10-year yield to maturity (YTM) to breach the 9 per cent mark for the first time since 2001. Oil companies were forced to draw on their credit lines at rates as high as 12 per cent. For corporate credit, it was even worse. The spread between corporate Triple ‘A’ paper over sovereign yields widened to 600 basis points. During this period, the 91-day T-bill yields rose above the 10-year YTM. In the first week of September this year, the 91-day yield was 9.05 per cent or about 20 basis points more than the ten-year YTM. Typically, high short-term yields and low long-term yields imply low investments and high working capital requirements, classic signs of an industrial slowdown.

CRR, SLR cut

It was at this juncture that the RBI stepped in to expand domestic liquidity. The CRR that was hiked to 9 per cent in June was rapidly cut to 5.5 per cent in November. Close to Rs 2 lakh crore of liquidity was released into the banking system. In November, the Statutory Liquidity Ratio was snipped one per cent to 24 per cent.

The stock markets had already collapsed under the weight of FIIs’ flight. Domestic investors shifted from volatile equity markets and mutual funds to safer public sector bank deposits. The accretion of bank deposits favoured bond markets. The investor pullout resulted in shrinking equity trade volumes on the National Stock Exchange, and increasing bond trade volumes. Late last month, there were occasions when debt trade volumes were more than double the equity trade volume, evidence of equities’ loss of favour, as a preferred source of investment.

For most domestic investors, the return to bank deposits or a complete reversal of disintermediation, was also facilitated by high returns offered by banks through structured schemes. The deposit interest rates offered were as high as 11 per centTime deposit growth in the banking system this financial year, till December, was 17 per cent as against 14 per cent for the corresponding period of last year.

Demand for securities

The resultant demand for securities hiked prices reflecting in a sharp fall in the ten-year YTM to 5.62 or 350 basis points over a period of three months. The 91-day T-bill yields on a weighted average basis dropped below 5 per cent, lower than the reverse repurchase rates. But yield drops are expected to bottom out, at around 5 per cent. One reason for this expectation stemmed from the high weighted average costs of working funds at 7 per cent currently. Unless there was credit expansion, average yields on assets are likely to sharply take a knock in the next financial year. Besides, there is some nervousness over credit quality in banking circles. Consequently, banks favoured shaving lending rates in the coming months. What also supported this trend is the low level of government borrowings. Redemptions and conversions have already reduced the outstanding MSS to Rs 1.2 lakh crore as on December 19 this year, as against Rs 1.68 lakh crore in March end this year. The steps were likely to release additional liquidity into the markets and temper rates next year.

Signs of weakening lending rates are already evident from the swipes at deposit rates. Banks have lost interest in CD rates, an indicator that there was little interest in bulk deposits. In fact, for the first time in four years, one year CD rates are about 300 basis points below the maximum deposit rates.