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Budget Dampens Bonds

This week, the rate cut of small savings trimmed bond prices too. Understandable, given the higher rate cut expectation, which was already built up. But bonds should turnaround, with reversal of perhaps an over-reaction last week.

Budget 2002 failed to trigger the bond rally. The 50-basis point cut in small savings rate was below expectations. The ten-year benchmark (11.03%, 2012) fell by Rs 1.30 over the week, pushing the yield by 14 basis points to 7.59 percent. The consensus was built around 100 basis point cut which was reasonably discounted in the bond prices. Obviously, bonds had to fall. But they recovered marginally on Friday, but remained well below their pre-budget levels.

The reduction in small savings rate is expected to narrow the already squeezed spread between call markets and short-term bonds, if repo rate is not brought down. On one hand, the call rates was around 6.6 percent, while on the other the yield on the 2004 G-Sec was only at 6.68 per cent on Friday. The call money rates remained above the repo rate of 6.50 per cent throughout the week. It touched 7.10 per cent amid higher demand for funds to meet any liquidity requirement on the Budget day. The repo rate has been at 6.5 percent for a while and with the kind of liquidity in the system it is likely to be brought down before the credit policy in April. The repo rate has a direct bearing on the overnight or the call money market.

The rupee also closed lower, shedding 4 paisa against the dollar. The rupee touched its lowest value this calendar at Rs 48.78 on Monday. But it soon firmed at Rs 48.71 on Friday, with dollar remittances from exporters.

Budget Highlights: Debt Market
Government Relief Bonds to have a reduction of 50 basis points in interest rate. A ceiling of Rs 2 lakh per year put on investment in these bonds.
Administered interest rate will now be benchmarked to the average annual yields of government securities of equivalent maturities in the secondary market. This will reduce volatility and bring more discipline in the debt market.
To help investors plan their investment better and to add transparency and stability in the market the RBI will announce an issuance calendar for dated government securities.
In the current parliament session, the government will introduce a new Government Securities bill to replace the old Public debt Act 1949.

Outlook
Bonds are more likely to jump again for a variety of reasons. The previous week's knee jerk reaction looks over-reaction. Besides, the mutual funds ran for cover selling bonds, anticipating large-scale redemption in wake of abolition of distribution tax. But it seems unlikely that funds will be faced with sizable redemption. And even if they do, it will find its way back into funds again through the growth option. Moreover, the financial system remains flush with liquidity to drive bond prices up again.