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Rally Takes a Breather

With the auction amount modest Rs 6,000 crore, bond prices could again see a brief spurt. At the same time, yields are unlikely to take a sharp dip since the markets are now in uncharted territory and await a fresh trigger

Sovereign bonds marginally extended their gains this week as the rally took a breather on profit taking and auction fears. The yield on the 10-year benchmark dipped to a historic low of 8.58 per cent on Monday before it firmed up to 8.64 per cent in the next two trading sessions. With a couple of holidays in the reporting week, call rates were a tad higher but came down to settle around 6.5 per cent on the back of ample liquidity. There was a brisk response to RBI's repo auctions with the apex bank mobilising Rs 5,800 crore. The rupee breached the 48-mark mid-week and touched 48.05 before closing the week strongly at 47.97 with sharp dollar inflows.

At its historic low, the return on the 10-year benchmark was at 8.58%, just 8 basis points more than the 8.5% coupon on 5-year GoI Relief Bonds. In fact, the yield is higher at a little over 12%, if one factors the tax-break for investors in the highest tax bracket. The government must address this anomaly at the earliest to bring down a secular decline in interest rates. This will also give banks enough leeway to cut both deposit and lending rates – despite nearly a month since the bank rate was reduced, banks have shied away from biting the bullet with fears of already compressed margins coming under more pressure.

The bad run for the economy continues with industrial production rising by only 1.6 per cent in September 2001 against 5.9 per cent for the same period last year. The non-food credit off-take has also shown a dip with the disbursement at Rs 4,600 crore last month against Rs 10,400 crore for October 2000. With little avenues for alternate deployment amidst an economic slump, the banking sector's investments in government securities has touched 40 per cent of aggregate deposits against the stipulated exposure of 25 per cent. However, there was some good news with oil dipping to $18.65 per barrel even though the OPEC has been attempting at cutting back production to rev up sagging prices.

Finally an Auction
The much anticipated auction announcement came on Thursday evening with the government planning to mobilise Rs 6,000 crore from sale of two bonds next week. Apart from 9.85%, 2015 paper for Rs 4,000 crore, the mobilisation programme will see the introduction of a floating rate bond (FRB). The FRB for five year will mop up the remaining Rs 2,000 crore. The bond will carry an interest calculated at a mark-up of two decimal places per annum which will emerge in the auction over a variable base rate. The base rate here will be an average of the implicit yield, which will be arrived at on the basis of the cut-off prices for the immediate previous six auctions of 364-day treasury bills. The auctions for the 364-day paper will be held prior to the half-year coupon period.

Outlook
With the auction amount a modest Rs 6,000 crore, bond prices could stage a brief rally. At the same time, yields are unlikely to take a sharp dip since the markets are now in uncharted territory. Hence, gains could be limited as uncertainty and caution creeps among market players. It seems the RBI is conducting its auctions in a phased manner to avoid any panic in the market. It would not come as a surprise if another auction is conducted this month, given the government's substantial commitments towards bond coupon payments and redemption of around Rs 14,000 crore in November. While yields at the long-end have taken a beating, the yield curve has become flatter with little gains at the shorter-end. Thus, the RBI could usher in a repo rate cut to bring down short-term interest rates and restore a healthy gap.