The Hindu Business Line : Yields head southward as inflation worries abate

Bangalore, May 11 Bond yields continued their southward momentum even as the second phase of the cash reserve ratio came into effect and traders shrugged off inflation worries.

The second phase of the CRR hike announced on April 18, removed another Rs 9,500 crore of liquidity from the banking system. In addition, another Rs 10,000 crore was mopped up through auction of government securities. The third phase becomes effective from May 24. The securities included the 7.59 2017 and the 7.95 2032. The securities were placed at a cut-off yield to maturities (YTM) of 7.96 per cent and 8.35 per cent respectively.

Besides, the inflation numbers had little impact on the southward course. Inflation, as measured by the wholesale price index, was 7.61 per cent for the week ended April 26. Traders said that high inflation had already been factored in. In fact, even the final inflation estimate figures for a prior period had little impact. The final figures for March currently out was 6.21 per cent, as against provisional estimates of 5.11 per cent.

Liquidity overhang

More than inflation, it was the liquidity overhang that dominated the markets. Part of the overhang was on account of the oil companies running down their credit lines. Bankers said that most of them had hit the prudential ceiling on advances to the oil refiners. Therefore, banks remained flush with funds. As a result, despite record high oil prices that topped $125 a barrel, liquidity remained in surfeit. This trend was evident from the weekend liquidity adjustment facility (LAF) auction. The recourse at the auction was to the reverse repurchase window. The RBI mopped up Rs 23,050 crore through reverse repurchase.

However, exchange rates plunged to Rs 41.38 or a drop of 1.8 per cent in one week due to oil companies’ foreign exchange purchases. Oil companies’ dollar requirement escalated by $15 million per day to about $265 million on the basis of current import prices of about $116 a barrel. Normally, recourse to reverse repurchases is associated with exchange rate appreciation, on account of heavy RBI purchases. But there was little RBI intervention in the exchange markets, largely due to outflows and depreciation of the rupee.

Special bonds sale

The divergent trend was due to changed market dynamics. With credit ceilings reached, public sector refiners funded import payments through sale of special oil bonds. Indian Oil Corporation sold about Rs 2,300 crore of oil bonds to the Life Insurance Corporation of India and to a clutch of provident funds at an average YTM of 9.22 per cent.

Hindustan Petroleum Corporation Ltd’s (HPCL) sale though, was not very successful. HPCL put up Rs 662 crore of bonds for sale, but found subscribers for only Rs 129 crore. One of the lead arrangers for the bond sales was A K Capital. A K Capital’s Assistant Vice-President, Mr Rohit Srivastava, said: “The response was lukewarm since some of the securities in the basket were not approved investments for the insurance companies and the Central Board of Trustees.”

Excess supply

But traders said, the lukewarm response was also largely due to excess supply of oil bonds. IOC has sold about Rs 17,000 crore of bonds so far.

Outstanding oil bonds are currently about Rs 62,000 crore and more such bonds are expected to be floated. The flood of oil bonds also pushed up the spreads to over 100 basis points over comparable sovereign securities. Traders said that the spreads could rise in view of the liquidity demand by oil companies. Oil companies used the resource to fund their crude oil imports.

Along with the spot exchange rates, one month forward premium also widened, as refineries took short forward covers. One month premium widened to 2.32 per cent (1.38 per cent). But exporters capitalised on the wide premia for the longer terms. As a result, three and six months softened to 1.84 per cent (2.56 per cent) and 1.55 per cent (1.92 per cent). Premium for 12 months though widened to 1.38 per cent (1.23 percent) on the back of import covering and corporate hedging of their foreign currency liabilities.

Treasury bill yields though softened reflecting the liquidity overhang. The yield on the 91-day T-Bill was 7.31 per cent last week, down from the previous week’s 7.35 per cent. The weighted yield was down to 7.26 per cent off 5 basis points. Bids, both competitive and non competitive, for a notified amount of Rs 3,000 crore amounted to Rs 11,092 crore. The retention though was only Rs 5,635 crore. At the 364 day T-bill auctions the retentions were Rs 4,150 crore, as against a notified amount of Rs 3,500 crore at a cut off yield of 7.55 percent.

The weighted average 10-year YTM slipped below 8 per cent to 7.91 per cent on a weighted average basis down from the previous week’s 8.08 per cent.

Volumes pick up

Trade volumes picked up further. Average daily trade volume was in excess of Rs 7,000 crore, well over previous week’s Rs 4,200 crore. Bid offer spreads remained narrow at 5 basis points, an indicator that the outlook for bonds was positive.

The drop in yields resulted in a further widening of the negative spread between inflation and the one year nominal yield.

The one year nominal yield was 6 basis points lower than inflation. Last week it was 3 basis points. This implied that inflation was clearly not a major worry.

The positive outlook for bonds though stemmed from low credit off-take. Since the beginning of this year, deposits continued to overwhelm credit. Credit-deposit ratio remained in the negative zone. Credit was a negative Rs 19,427 crore, implying redemptions. Bankers said that some of the redemptions were on account of window dressing that some of the large banks had resorted to during March-end.

With the redemptions and low credit off-take, the rally in the bond markets is likely to be sustained. More banks are now moving up the yield curve, or investing in longer tenure government securities. Besides, the high coupon securities have vanished from the markets. Low coupon securities come in only when yields are expected to soften. Among the securities that have vanished include the 9.39 per cent 2011. This security is currently unavailable even at YTM of 7.50 per cent.

Bankers said that the rally is likely to remain till such time the oil companies’ credit lines are reworked and the ceilings enhanced.

In the mean time, investments are likely to remain the focus. The focus is evident from the incremental investment-deposit ratio of 800 per cent as against the nominal ratio of 32 per cent.

Clearly there is little need for deposits. Bankers are now preparing to roll back deposit rates. As they wait for the first one to make the move, some have quietly begun discouraging deposits and redeeming time deposits.