Bonds still carry huge price risk

B. Venkatesh

Bonds continued to remain bid in the last fortnight. Going forward, they carry huge price risk, and the downside from the current levels far outweighs the upside.

Consider the following factors:

First, bond yields have contracted sharply in the last month. The one-year bond yields have dropped 42 bps, 5-year yields, 30 bps while the 10-year yields have fallen by 50 bps. With the 10-year yields currently at 8.64 per cent, banks are trading on thin spreads since the average one-year deposit rate is still around 8 per cent. This clearly caps the room for dealers to bid up prices.

Second, the price risk is large at the long-end of the yield curve. The term spread between the 10-year and the 20-year bonds has been compressed to just over 50 bps, while the spread between the one-year and the 10-year bonds is 180 bps. The lower-than-normal spread between the 10 and 20-year bonds gives good cause for long-term yields to rise.

Third, the RBI has scheduled two bond auctions in the coming week- Rs 4,000 crore 14-year bonds and Rs 2,000 crore 5-year bonds. Dealers may be wary of further bidding up bond prices on the run-up to the auction as firm prices may prompt the RBI to lower the cut-off yields.

Fourth, with the OPEC countries, Russia and Mexico in talks to cut crude production, there is a possibility of a rise in the OPEC oil basket-price. While the price rise may not immediately affect the country's external account, the negative development is likely to impact the sentiment in the forex market. And that may have an adverse bearing in the bond market. Dealers may, therefore, be unwilling to bid up bond prices to further highs.

Amid such negative factors, the only positive factor, which is likely to keep banks' trading books in the positive territory, is the comfortable liquidity in the market.

The overnight rates have eased after tight liquidity conditions in the previous fortnight. This provides banks some spread by borrowing on calls and investing in bonds.

Of course, bond dealers may be careful in the term-arbitrage deals, as a volatile rupee may tighten overnight rates, and place huge price on the banks' trading books.

On balance, the negatives seem to overwhelm the positives, which all means that bonds carry downside price risk.