The Hindu Business Line : Outlook for bonds remains bearish

BONDS went into a tailspin last week as foreign flows slowed down considerably and markets speculated about a possible hike in domestic interest rates.

Traders also said that any hikes would be possible only after the Federal Reserve Board announces its decision. Most traders anticipate a hike in the crucial federal funds rate.

The inflation numbers released on Friday also contributed to pushing down the prices. The numbers showed a jump in the wholesale price index to 5.5 per cent, up from the previous week's level of 5.1 per cent.

Oil prices also rose during the week after a spate of attacks on pipelines in Iraq and the fears that the conflict was likely to spill over into Saudi Arabia.

Most oil companies rushed for covering their forward positions, especially in a situation when they would have to meet the payments for maturing contracts. There are fears that prices upward of $40 a barrel would be revisited. Adding to this was also the selling trickle by foreign institutional investors in the market. This slow selling was partly due to fear that larges scale selling would lead to a steep depreciation of the rupee and consequently negate their gains.

These trends were reflected in the low mop-up amount in the weekly repos. Last week, the mop-up was about Rs 9,600 crore. This was despite the large coupon/ redemption flows equivalent of at least Rs 11,000 crore. It is also interesting to observe that the RBI has shifted to a three-day repo instead of seven-day repos.

In the 91-day T-bill auctions, yields rose to 4.5 per cent. Bankers said that there was no liquidity tightening in the markets. Part of the reason for this was despite the large mop-ups of Rs 2,000 crore and another Rs 9,000 crore by way for dated securities, the repo auctions still elicited a good response. The securities were placed at yields close to market rates. The 11-year paper, 7.38 2015, was placed at 5.58 per cent and the 24-year paper 6.13 per cent 2028 at 6.29 per cent.

According to Mr K.V. Hegde, General Manager (Investments), Canara Bank, "Liquidity is not likely to tighten in the coming weeks. This will certainly not happen before the Budget."

Despite this optimism, the 10-year yields crashed to 5.49 per cent on a weighted average basis. In fact, on the last day of the week, the yields had punched below the 5.55 per cent. When prices dropped sharply, insurance companies, in particular the LIC and the General Insurance Corporation bought long-dated high-coupon bonds. As a result, the yield curve between 15 years and 24 years flattened out. The yield differential between 15 year and 24 years was barely two basis points per year as against 11 basis points up to 15 years.

Traders said the outlook remained bearish. This was particularly in view of the widening spreads between one year and 24 years. These spreads last week increased further to 174 basis points. Trading volumes also remained low.

Bankers believe that the repo rate would be hiked after the Budget.

Also, they expect the borrowings to overshoot the estimates made in the interim Budget. This was especially since some of the committed expenditure, (read revenue expenditure) for the ostensible purpose of rural development was expected to be funded through borrowings.

Moreover, the reserve money build-up through foreign currency accretions has already vanished. Foreign exchange inflows have now reduced to a trickle. In fact, for the latest reporting week, the foreign exchange flows continued the four-week trend of negative flows. Last week, it was $333 million. This outflow was despite the fact that no prepayments of borrowings have taken place during the month.

Bankers said that exporters had stopped taking forward covers. Instead, most of them brought in only small volumes of their receipts through the spot markets, in anticipation of a further weakening of the rupee in the coming weeks. Besides, non-debt capital account flows have also reduced to a trickle. Such flows were likely to take place only after tax proposals were known in the Budget.

Such moves were also ready beginning to have an impact on the forward market. Forward premiums are currently at 0.5 per cent for six months, a complete reversal from the forward discounts and a weakening rupee against the dollar.

What is also expected to influence the forward premium yield outlook is the quantum of hike in the Fed funds rate. Presently, 10-year US Treasury yield is 4.9 per cent, at least 160 basis points above the previous year's level.

The improved yields have pushed some of the foreign institutional investors out of the domestic market into their home terrain where fixed income returns have improved.

Traders said that there was pick-up in food credit offtake. Food credit has been picking up in recent weeks. Food credit grew by at least Rs 1,280 crore. Non-food credit growth, however, has slowed down considerably, some banks continued to report growth.

Part of the slowdown in non-food credit offtake was partly on account of the fears by corporates over the Budget. In fact, some of the corporates fear that additional taxes on some goods were likely to impact the offtake and demand projections. This in turn, they said, would adversely impact their investments.

Corporate fund managers preferred to wait for the Budget before taking a cue for further credit drawdowns.