The Hindu Business Line : Bonds rally on hopes of low inflation, large capital flows

Several domestic corporates have begun tapping 15-year foreign currency debts through medium-term note issues in view of the attractive pricing. Credit growth slowing even as deposit base expands

Bangalore , Sept. 3

Bonds continued their extended rally propelled by purchases by life insurance companies and foreign currency inflows.

Bankers said what also helped the rally was the flagging international oil prices, now under $70 a barrel. This meant that the weighted average price for India's oil imports would now be close to about $65 a barrel or about $475 a tonne.

The drop and expectations of further retreats resulted in some of the oil companies' reduction in foreign exchange demand and decreased drawdown on their credit lines from the banks. Bankers said this had resulted in increasing the liquidity levels. Traders said that most global hedge funds were off-loading their oil futures/options, an indication of the bearish market expectations.

Ample liquidity

Consequently, liquidity is likely to remain surfeit within the domestic banking system. The expansion in domestic liquidity was evident from the large mop-up through reverse repurchases at the week-end liquidity adjustment facility auctions. The two auctions mopped up Rs 41,165 crore. At the weekly Treasury bill auctions, yields also remained down. The cut-off yields at the 91-day T-bill auctions were 6.44 per cent. But the weighted yields were five points lower at 6.39 per cent, implying that some of the bids were far lower than the cut-off yields. The previous week, the cut-off yields were 6.40 per cent. The cut-off and weighted yields for the 364-day T-bill auctions were 6.93 per cent and 6.91 per cent respectively.

The high liquidity was also evident from the softening of the 10-year yield to maturity (YTM). The ten-year YTM was 7.92 per cent last week on a weighted average basis down from the 7.99 per cent the previous week.

Trade volumes in the market have picked up. Daily average trade volumes were above Rs 1,000 crore, though far lower than those seen in 2003 and 2004. But traders said that the bid-offer spreads were narrow at about 5 basis points, an evidence of sustainability of the rally.

Moreover, yield spreads between one year and 29 years are currently about 147 basis points, down from August average of about 185 basis points.

Traders said that bonds were also buoyed by low inflation expectations. Inflation for the latest week was 4.91 per cent, translating into a one-year real yield of 2.1 per cent. The high real yield gave considerable leeway for a further softening to international real yield levels of about 1.5 per cent.

Besides, credit-deposit ratios of the banks are also beginning to retreat.

Nominal CD ratios are now at 7.5 per cent, down from 72 per cent in June this year. Incremental CD ratios are under 100 per cent. But bankers said that this was largely on account of expansion in deposit base. Deposits have sustained a growth of 22 per cent for the banking sector and credit growth rates were dropping fast. Credit growth for most banks were under 25 per cent. In fact, this year most banks are targeting a credit growth of just 20 per cent, bankers said.

Capital inflows

The rally was also expected to be sustained by large capital inflows. Several domestic corporates have begun tapping 15-year foreign currency debts through medium-term note issues in view of the attractive pricing. In addition, non-debt inflows are also beginning to escalate in the form of private equity flows and non-resident interest in the domestic equity markets. Besides, export-driven flows were also growing. This was evident from the low forward premia. Forward premia for up to a year was under 1.25 per cent. If the current inflows sustain, bankers said that at the short-term premia were likely to level off. This, in turn, implied that yields were likely to see further softening.

However, the flip side was credit growth. The peak season was yet to commence, and interest in bonds were unlikely to remain high other than for maintaining the statutory liquidity ratio of 25 per cent. In fact, most banks' current holding of securities was only about 27 per cent. The only interest for bonds was likely to be only for meeting this ratio in view of the high deposit growth. Bankers are now more obsessed with maintaining the net interest margins of 3.25 per cent and treasury operations currently fail to meet those expectations.

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