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Bond traders see yields hardening

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C. Shivkumar

BONDS remained weak last week in a lacklustre market characterised by thin trading as bankers prepared for the redemption of the maturing Indian Millennium Deposits.

Traders said the weakening was triggered by continuing rise in oil prices, which have moved closer to $59 a barrel.

As a result, oil companies chased dollars for meeting their import payment obligations for both crude and products.

Bankers said they were also selling government securities for funding year-end credit demand from small and medium corporates. What dampened sentiment was the restricted presence of life insurers. Bankers said most of them preferred the equity markets, where the returns are currently far higher, especially with the Sensex poised to punch the 10,000 barrier.

Liquidity tight: Liquidity, as a result, remained tight during the week. Banks consequently took recourse to the RBI's repo window at 6.25 per cent.

Bankers drew about Rs 1,500 crore from the RBI through the week-end three-day Liquidity Adjustment Facility auctions. The reverse repo mopped up only Rs 7,720 crore during the LAF auctions.

The tight liquidity also manifested in the high cut-off yields at the Treasury bill auctions last week. The cut-off yields on the 91-day T-bills were fixed upwards of 6.02 per cent, though the weighted average yields were lower at 5.94 per cent. The previous week, the 91-day T-bill yields were at 5.78 per cent. The 364-day T-bill yields were at 6.17 per cent (6.14 per cent). The higher fixing for the 91-day T-bill yields triggered speculation of a possible hike in the reverse repo and the Bank Rate during the credit review meeting of the RBI.

Marginal impact: However, the tightening had little impact on the 10-year yield to maturity (YTM).

Last week, the 10-year YTM, on a weighted average basis, was 7.18 per cent, slightly higher than 7.17 per cent the previous week.

Insurers and funds took full advantage of the tightening and replenished their portfolios using switches, traders said. Switches implied swapping of long-tenor securities at high yields and sale of short-tenor securities at low yields.

Preferred securities: The favoured securities by the life insurers were the 10.03 per cent 2019 which was picked up at 7.47 per cent, the 10.25 per cent 2021 at 7.38 per cent. These securities were switched for the 7.55 per cent 2010 and the 7.40 per cent 2012.

Bankers were mostly sellers of long-dated securities, partly on account of credit demand and the need to align their investments closer to the statutory liquidity ratio.

Bonds were not influenced by the slight drop in inflation to 4.5 per cent, because there was little change in the real yield for one year, which remained grooved between 1.5 per cent and 1.75 per cent.

The key factor was the IMD redemption, expected next week, for which State Bank of India has been accumulating forex exchange.

This was despite anticipation of a large-scale rollover of funds to domestic non-repatriable rupee deposits by some of the non-resident Indians.

Not keen on rollover: However, bankers said the indications were that the RBI did not favour such a rollover, fearing a liquidity overhang. This was especially at a time when domestic rates were higher than international rates.

A rally in the bond markets therefore appeared unlikely. Instead, traders said a further hardening of yields was expected.

This was partly on account of the firm forward premia. Forward premia for up to six months was above one per cent.

Traders said this was because most of the oil companies were now taking forward cover.

Unlike the past few were prepared to leave their payment positions unhedged.

This was particularly because none of them are presently permitted to fully transmit the costs on to retail tariffs. But bankers said corporates, with international acquisition plans, were also taking forward cover at the current strong exchange rates.

A major cause for worry among bankers was the slowdown in export growth, though the non-oil trade account still continued to remain favourable.

Low volumes: The uncertain outlook for bonds was also evident from the low trading volumes. Daily average trading volumes were barely Rs 700 crore. But spreads between one and 23 years were narrowing, indicative of an imminent technical correction.

The spread was 138 basis points. One reason for this expected technical correction, bankers said, was the foreign inflows anticipated during the next few weeks.

Some of the exporters, bankers said, who had deferred their inward remittances, anticipating a favourable exchange rate, were likely to begin repatriation. This anticipation has left forward premia above one year at less than one per cent.

Besides, the non-debt account capital inflows were from East Asian institutional investors. These inflows have led the foreign exchange reserves to swell to $145 billion.

The rise of $1 billion also took place despite the large oil demand for foreign exchange. But bankers said that unless such inflows took place on a sustained basis, there were unlikely to be any major impact on domestic interest rates.

Key driver: Credit continued to be a dominant driver for yields. Credit-deposit ratios for most banks are at a record 70 per cent. On an incremental basis, the ratio was higher than 100 per cent. In fact, to sustain this demand, bankers have already started soliciting medium term deposits, since the demand was mostly for term funds. A lending rate hike therefore appears to be in the making, though bankers preferred to wait for a cue from the RBI.

(This article was published in the Business Line print edition dated December 26, 2005)
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