The Hindu Business Line : Bonds firm up on increased liquidity

Bonds firmed up last week on the back of increased liquidity, powered by large foreign exchange inflows, as traders shrugged off the impact of high international oil prices.

Traders said that what also contributed to the high liquidity was the strike by the employees of State Bank of India.

The strike has resulted in the State Bank group becoming large lender since the bank was neither disbursing any credit nor salaries to the millions of government and public sector employees and pensioners who are its customers.

Besides, oil companies also maintained a low profile in the markets since some of them had already tied up their purchases, which are yet to reach the country.

Consequently, foreign exchange demand from oil companies was low.

But, traders said, the inflows into the country were large, touching close to about $200 million per day and exerting pressure on forward premia that dipped below 1.5 per cent across all tenors.

This triggered RBI's market interventions, leading to liquidity infusion and consequent large mop-up through reverse repos.

LAF auction

At the week-end Liquidity Adjustment Facility auction, the RBI mopped up over Rs 32,000 crore.

The liquidity build-up pushed down the 91-day Treasury bill yields to below 6 per cent. The cut-off yield on the 91-day T-bill was 5.78 per cent last week, the lowest since the beginning of this year and down 33 basis points from the previous week. The Chairman of Vijaya Bank, Mr Prakash P. Mallya, said, "With this kind of liquidity, we can forget about any CRR cut."

But the 10-year yield to maturity on a weighted average basis eased slightly to 7.45 per cent, down from the previous week's 7.47 per cent.

Firm undertone

The undertone was firm last week. Daily trade volumes were close to Rs 1,700 crore. But most trades were confined to the short-end, implying the bias for short maturity bonds. This preference was driven essentially by the need to remain liquid. Yet, with yields on long-term securities for 28 years and 29 years near three-year highs, life insurance companies stepped in to make purchases. But, life insurers' purchases were mostly in small lots since the Life Insurance Corporation preferred to wait for the planned primary auctions of the 7.5 per cent 2034 security next week for Rs 3,000 crore and also the 10-year security for Rs 5,000 crore.

As a result of the bias for short-tenor securities, spreads widened to 151 basis points, implying a steep yield curve. This also indicated interest rates in the short run were likely to remain stable, traders said.

The yield reversal was also attributed to the low inflation rate of 3.96 per cent. This resulted in a reversal in the real yields. Real yields, for one year, dropped to 2.36 per cent after moving close to 3 per cent the previous week.

Real yields

Traders said that this indicated that the real yields were on the higher side. Globally, one-year yields are only about 100-150 basis points above inflation. Consequently, what was happening was a correction, traders said.

Despite the short-term bias, traders said the auctions for the two dated securities were likely to go through successfully. This was particularly on account of the new underwriting mechanism in place. Besides, the low underwriting fees quoted by the primary dealers indicated that the placement was unlikely to face difficulties.

A crucial element driving yields was the build-up of liquidity through reserve money flows, in particular foreign currency, bankers said. In fact, a large quantum of foreign currency inflows originated from non-resident Indians wanting "a piece of action from the Indian equity markets." This sentiment is likely to power the rally in the bond markets in the coming weeks as well.

Yet, bankers said that any rally in the bond markets would only be short-term. This was because credit demand would drive the bond markets. Besides, with an investment-deposit ratio of close to 38 per cent, bankers said, there was little incentive to pick up government securities unless yield expectations were above the weighted average cost of working funds.