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Sunday, Mar 31, 2002

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Range-bound movements likely

BONDS ended lower last week. The yield curve saw a near-parallel marginal downward shift, with the 10-year yields ending 8 bps higher than that at the end of the previous week.

Going forward, the bond market is likely to remain range-bound due to opposite forces acting on the market. Consider this.

First, on the positive side, the RBI has announced a calendar for government bonds. This enables banks (and PDs) to allocate resources more efficiently between the primary and secondary market.

On the flip side, the calendar indicates that the RBI will hold bond auction totalling Rs 7,000 crore in the first week of April. This may be bad news, as bond prices typically remain bearish on the run-up to primary auctions.

Second, on the one hand, banks may not be very concerned about protecting their trading book against price risk, as the coming week will be the start of FY 2003. This may force them to bid up bond prices, notwithstanding the huge price risk at present.

On the other hand, spreads have tightened further, especially at the front-end of the yield curve. For instance, spreads between the 2-year and 3 year bonds are only 8 bps against 15 bps the previous week. This has made most maturity sectors rich. At present, the only sector that appears cheap based on yield spreads is the eight-year maturity.

Besides, yield volatility (vols) of the benchmark 10-year, five-year and one-year bonds fell sharply during this week. This suggests that there is no advantage for duration extension, as lower yield vols reduces convexity gains.

Third, the positive development is that the third-quarter GDP growth rates suggest that the economy is cantering at a decent pace. But this could actually have a negative effect on bonds, as a better GDP growth rate could well put the spanner-in-the-works for further rate cut, and consequently, to a likely bond rally.

B. Venkatesh

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