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Bulls Out in Full Strength on Bond Street

With the cut in CRR, market players are now expected to bid on hopes of a repo rate cut - if it does not materialise in the near-term, markets could see some volatility with hardening of yields

Spiraling call rates failed to derail the bull-run on bond markets with the yield on the benchmark (11.5%, 2011) dipping to a new low of 8.77 per cent. Since the announcement of the credit policy, the yield on the 10-year paper has dropped by 35 basis points. Market participants bought aggressively before the first round of CRR cut on Saturday in anticipation of a further drop in yields. The reduction in CRR will release Rs 6,000 crore into the system and is widely expected to flow into sovereign bonds in the absence of a tangible credit offtake from the corporate sector.

On the other hand, call rates touched a high of 18 per cent as some banks scurried for funds on reporting Friday before they came off sharply to close under 7 per cent after large supplies. Call money continued to run high during the week – while traditional lenders diverted investments to the gilt market; there was also disappointment since a much anticipated repo rate cut did not materialise. The Reserve Bank of India pumped in over Rs 12,500 crore through reverse repos to cool down call rates.

The bad run for the economy continues with exports falling by 8.61 per cent to $3.52 billion in September 2001. Imports also dipped marginally to $4.18 billion in September this year from $4.25 billion during the same period last year. In the first half of the current financial year, exports have dropped by 1.95 per cent while imports have risen by 1.81 per cent, thus widening the trade deficit to $4.96 billion. The net revenue realisation has also taken a beating in the first seven months due to higher refunds with a collection of only Rs 88,000 crore against Rs 91,000 crore for the same period in 2000.

For the first six months, the fiscal deficit was high at Rs 57, 262 crore or 49.2% of the target of Rs 1.16 lakh crore for the current financial year. It was only 38.3 per cent of the target for the same period last year. Clearly, while the government's revenues have taken a beating, it has not been able to rein its expenditure, as reflected by its aggressive market borrowings. It is now certain that the government will again miss its targeted fiscal deficit of 4.7% of the GDP this year and end up borrowing more than the stipulated Rs 1.18 lakh crore from the market. Last but not the least, the first half numbers reveal that the plan expenditure has not shown any increase and was more or less at last year's levels. Thus, the figures are contradictory to the government's tall assurances to step up spending to revive the economy.

Attractive Spreads But…
With the unabated bull-run on bond markets, the yields on government securities have touched historic lows. However, the rally has not yet percolated to corporate bonds, thus widening the spread between company debt and gilts of similar maturity. The spread is currently pegged around 150 basis points – while the yield on five-year gilt is around 7.2 per cent, it is hovering at 8.7 per cent for a top rate corporate bond. The spread is higher for triple A bonds with poor liquidity.

While spreads are surely tempting, big buying is unlikely to emerge in a hurry. Mutual funds, who have traditionally invested heavily in corporate bonds, are currently buying into gilts to recharge their liquid assets. Bond funds were forced to liquidate their sovereign holdings in September to meet heavy redemption pressure. Two, the scare of a deteriorating economy is keeping investors at bay. So far, there have been five AAA downgrades and more could be in the offing. Thus, banks are also staying away from corporate bonds due to NPA fears and stringent prudential norms. Anyway, most banks do not have adequate capital to make a 100 per cent provision for these investments and thus, are forced to stay away.

Outlook
The fresh bout of liquidity could further pull down yields with the 10-year bond expected to touch 8.7 per cent. However, any sharp dip may see OMOs and auctions from RBI to stabilise yields. Call rates are now expected to stabilise below 7 per cent with the start of a new reporting fortnight. It is likely that the RBI will announce an auction next week to take advantage of low interest rates and buoyant sentiment. Further, with the CRR event over, market players are now expected to bid on hopes of a repo rate cut – if it does not materialise in the near-term, markets could see some volatility with hardening of yields. Importantly, despite the bull fervour, markets are highly susceptible to an event risk – thus, invest for the long-term!