The Hindu Business Line : Bonds weak on oil concerns, $ loan prepayment

BONDS fell last week despite a surge in foreign currency inflows, driven by uncertainty over rising oil prices and the consequent impact on domestic inflation.

Traders said that corporate rush to shed foreign currency liabilities also accelerated the drop. Corporates have been mostly taking advantage of the weakening dollar and prepaying or swapping some of their debts into domestic currency. The move out of dollar-denominated loans stems from anticipation that US interest rates may be hiked , when the US Federal Reserve Board's FOMC meets again this week.

So far, the Federal Reserve has carried out seven increases in the funds rate, of a quarter per cent (25 basis points) each time.

For corporates, these hikes would imply debt-servicing costs would escalate. This is because most foreign currency loans accessed are on floating rates.

Oil prices: These events have coincided with the rise in international oil prices. International oil prices are at record highs, trading at over $57.02 a barrel. Despite the high prices, real oil prices are still low.

For India, the rise in nominal oil prices implies that the average import prices are close to $51 barrel or about $400 a tonne, inclusive of customs duties. This has driven oil companies to lock into the current foreign exchange rates so as to partly offset the increased prices.

Borrowing schedule: Moreover, bankers said that they were awaiting the government's borrowing calendar for the next financial year. The borrowing schedule is likely to be announced next week. In anticipation, most traders preferred to remain liquid.

As a result of these trends, the surplus liquidity failed to impact the Treasury bill auctions. At the auctions, T-bill yields remained steady. The yield on the 91-day T-bill was 5.20 per cent, unchanged from last week.

The 364-day T-bill yield also remained steady at 5.61 per cent, almost at the same level as the previous fortnight. Interestingly, there was little deviation in the weighted average from the cut-off yields. This was despite the fact that at each of the reverse repo auctions the mop-ups have remained above Rs 25,000 crore. This was because few bankers were prepared to take any kind of risks at the financial year-end.

At the weekend three-day reverse repo auction, the RBI mopped up over Rs 31,000 crore of liquidity, mostly driven by foreign currency inflows.

These inflows not withstanding, the 10-year yield to maturity hardened to 6.71 per cent on a weighted average basis last week, up from the previous week's 6.65 per cent.

Weak undertone: Trading volumes were also low, indicative of the weak undertone.

Average daily trading volumes were barely Rs 2,000 crore during the week.

Moreover, the outlook also remained bearish, evident from the high spreads between one year and 23 years.

However, yields at the long end remained flat. This was partly due to the presence of life insurance companies. Some securities at the long end were available below their respective coupons as in the case of 6.01 per cent 2028 and the 6.13 per cent 2028.

Bankers said that LIC also picked up large volumes of the 10.25 per cent 2021 security at 7.08 and the 8.35 per cent 2022 at 7.01 per cent.

The hardening of yields has already triggered some worries. This was partly because some of them were likely to still end up making large depreciation on their securities portfolios marked to the market.

This was despite the one time RBI reprieve last year, which allowed them to increase their held-to- maturity (HTM) portfolios up to 25 per cent of their demand and time liabilities.

This would still leave banks with a large portfolio of securities to be marked to market since the investment-deposit ratio is at 44 per cent.

Rising inflation: Anticipation of further hardening in yields was also triggered by the rising inflation rates. Inflation as measured by the wholesale price index rose to 5.3 per cent, partly driven by high fuel prices.

This resulted in a narrowing of real yields. Real yields though positive narrowed to about 30 basis points last week, down from 70 basis points.

Moreover, large foreign fund inflows were also responsible for triggering inflation, bankers said, by raising the money supply in the domestic markets and also for RBI's interventions to stem the dollar tide into the markets. Last week, exchange reserves hit a record $140.429 billion on the back of $2.9 billion inflow.

Inflows were partly triggered by the weakening dollar. However, there were also substantial inflows on the merchandise trade account.

Forward premia, as a result, for one month to twelve months was below 1.5 per cent.

Prepayments: Some worry was building up in top banking circles about the large foreign currency inflows.

In fact, some are already clamouring for more prepayments of external debts to contain increases in domestic money supply and at the same help reduce the debt burden and thereby the fiscal deficit.

What also worried bankers was the possibility that rising foreign interest rates would lead to a sudden exodus by volatile foreign institutional investors and unsettle the financial markets.

Fears were that the sudden outflows would trigger a sharp rise in domestic interest rates and stifle growth.

Already, bankers are on a roll with credit-deposit ratio at 64 per cent.

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