One of the major triggers for the sharp fall in bond prices was the auction cut-off yield of 6.85 per cent for 2012 paper.

S. Balakrishnan

INDIAN bonds are down again. The 10 years breached the psychologically crucial level of seven per cent late last week.

The yield on the market bellwether, 7.38 per cent 2015, has risen over 50 basis points from its lows below 6.5 per cent.

Most of the increase took place only after the close of the last financial year, so banks and mutual funds should have escaped significant damage and provisioning for their balance sheets.

One of the major triggers for the sharp fall in bond prices was the auction cut-off yield of 6.85 per cent for 2012 paper at last week's auction. Although it was a reissue of an illiquid paper, the yield was close to that on the 10-year benchmark.

The central bank went ahead and made full allotment to the bidders, refusing to opt for devolvement, despite the bidders' high yield expectations. If the market wanted to test the RBI, it clearly did not succeed. Does it signal the RBI's comfort with rising interest rates at the long end? Recent inflation data has been relatively interest rate-friendly, the WPI having come down from highs of above 8 per cent to just over five per cent.

Yet, bond yields fell less than one per cent from their peak of 7.35 per cent. A major reason for sticky yields has been the spike in world oil and commodity prices, effectively putting a floor on how far inflation can fall.

Even if the Government holds off increasing petro prices for as long as possible to keep down inflation, it will have to resort to more market borrowings to compensate the oil companies at least partly for their higher crude costs. That could put more pressure on an already nervous market. Banks are still placing tens of thousands of crores with the RBI on reverse repos, suggesting liquidity is comfortable. But, we may have seen the best of it.

Forex reserves seem to be plateauing, given our spiralling oil import bill and the likely slowing of inflows, the latter because of the narrowing interest differential between the rupee and the dollar.

The last nine months have seen Fed Funds move up 1.75 per cent while our repo rate rose only 25 basis points. Credit is picking up and a good monsoon will see a better investment climate and more consumer spending.

Still, unless things get really bad, the Government and RBI appear to have decided to stick to "no change" in the repo rate. The spread between longs and the repo rate is over 2.25 per cent and could push to around 2.5 per cent.

Bonds are clearly moving into "buy" territory.

(This article was published in the Business Line print edition dated April 13, 2005)
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