The Hindu Business Line : Bonds' outlook weak

BONDS went into a tailspin as financial markets were worried about inflation and a potential escalation in Government borrowing requirements for the current fiscal.

Traders said that what also helped drive up yields were the shrinking foreign exchange inflows and its impact on domestic liquidity.

Besides, foreign exchange outflows in the last few weeks have escalated, partly driven by oil payments. Oil payments have risen last week driven by escalation in international prices. International prices touched a record $43 a barrel. Consequently, the payment liabilities of the domestic companies also escalated considerably.

Depreciating rupee

With the rupee depreciating rapidly against the dollar, the effect on costs was substantial, traders said. Almost all the oil companies were in the market for hedging against rupee depreciation for some maturing payments. As a result of this dollar demand, some of the banks sold their securities portfolios leading to a fall in bond prices or a rise in yields.

This trend reflected in last week's market stabilisation scheme auctions. The auction saw the yield on the 4.83 2005 security breach the 5 per cent mark to 5.05 per cent. Besides, during last week's auction 91-day T-bill yield also saw yields remaining steady at 4.52 per cent. But both these auctions were supported by large fund flows into the banking system during the week. The inflows included, coupon flows of about Rs 2,000 crore, redemption payments of treasury bills, corporate debt service payments and off course deposit flows.

Yet despite these flows, the outstandings on the repo auctions have continuously dropped. Last week's repo auction saw the outstanding drop to Rs 50,000 crore though the mop up was around Rs 10,000 crore.

MFs turn sellers

Further, traders said that mutual funds were also selling in the markets as second and third rung corporates opted for redeeming some debt funds, fearing further erosions in their net asset values. This week however, most life insurers stayed away. This resulted in the ten- year yield to maturity move to 6.17 per cent last week, from last week's 5.97 per cent.

During the week, ten-year yields had also touched 6.30 per cent, though what pulled up the yield slightly were reiterations by the RBI that inflation would be within the targeted 5-5.5 per cent band. But the undertone in the markets remained weak. Trading volumes remained in the Rs 2,500-3,000 crore band, moving to the upper end only during the intervention of the insurance companies.

Poor response

The tight market conditions resulted in a poor response to the State development loans. This was evident from the subscriptions, where the shortfall in realisation was at least Rs 2,100 crore as against the targeted amount of Rs 8,600 crore.

The low subscription was despite the fact that the bonds were on tap. Traders said that unlike in the past there was little interest in securities above 5-year maturity time frame. Further, the coupons on offer on this security clearly fell short of market expectations, traders said. State development loans are generally treated as illiquid securities, though during the last two years, these securities had found takers in view of the surfeit of liquidity. The outlook for the coming week also remained weak, traders said. This was evident from the high spreads between one year and 24 years. These spreads are now over 200 basis points.

The major reason for the poor outlook was the real yield expectations. Real yields, the difference between nominal and inflation, up to 12 years were in the negative zone, despite the inflation remaining flat during the week.

Yields on US Treasuries are currently in the region of about 4.40 per cent for ten years, or at least 2.5 per cent above the prevailing inflation rate, even after factoring in the current oil prices.

Oil prices were outside the purview of the Government. As a result, one more round of domestic petro-product price hikes are expected. This is likely to have a cascading effect on the economy. Further, traders indicated that foreign exchange movements are also likely to influence yields.

Hold back remittance

Current account inflows have completely stopped. Part of this reason was that exporters continued to hold back their inward remittances, anticipating a further depreciation in the rupee.

Besides, import demand for the first time in more than a year has outstripped inflows, resulting in the rupee's depreciation. In fact, during the last few weeks, the RBI has intervened heavily in the domestic markets.

Last week, the RBI sold about $1.5 billion, the highest outflow in more than two years, without any debt prepayments, bringing the foreign exchange levels below the $120 billion mark. The outflows are likely to continue was evident from the widening forward premia. One-year forward premium closed at 2.75 per cent.

Three month forward premia was close to 5 per cent, implying that in the near term, the rupee is likely to weaken further. This in turn implied that yields were likely to move up further in the coming weeks.

Funds for drought

Further, State Governments are expected to push for greater demands for grants for funding drought expenditure, all of which is likely to translate into greater borrowings from the markets.

Besides, credit offtake has been rising, mostly non-food credit offtake. Large volumes of this credit expansion were driven by the rural markets, bankers said.

In fact, non-food credit during the last reporting week went up by over Rs 4,500 crore.

This was partly because time deposits of the banks have also risen by over Rs 10,000 crore during the period. But these trends have resulted in pushing up the costs of corporate borrowings.

Yields on corporate securities are at least 125-150 basis points above sovereign yields.

This shows that the sub-PLR (prime lending rate) fund raising regime by top corporates is slowly beginning to end with the tightening of the liquidity.