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Political Instability Hurt Bonds

With NDA-led government voted out of power, Indian bonds took a severe beating. Though inflation dipped, steep rise in global oil prices dampened sentiment. The 10-year yield touched a 2-month high of 5.2 per cent.

Just like equity markets, bond markets too had a tough week. The surprising outcome of elections, steep rise in global oil prices and the fear of US interest rate hike led to a demolition in bond prices. Though inflation came down for the second week, it failed to cheer market sentiment amid fear of rise in domestic fuel prices. Thus, in a choppy and eventful week, the yield on the 10-year benchmark, (GOI 2014, 7.37%) closed at a two-month high of 5.20 per cent on Friday – up 8 basis points over the week.

Though exit polls had suggested that the NDA coalition would fall short of majority, the final results were still a surprise. The Congress-led alliance got most of the seats. As they didn't have the majority, they are most likely to form the government in alliance with the left parties. And since left parties are against disinvestment, this could well put a brake on the reform process. This badly affected the market sentiment resulting in sharp fall in bond prices.

The fall in bond prices was sharper in the corporate bond market as compared to the gilts market. The yield on the 5-year benchmark corporate bond rose 15 basis points over the week to close at 5.78 per cent. On the other hand, the yield on the 5-year government bond (GOI 2009, 11.99%) closed at 4.92 per cent – up 13 basis points. Consequently, the spread between the 5-year corporate bond and government security widened to 87 basis points this week from 82 basis points in the previous week.

On Wednesday, RBI auctioned Rs 1,500 crore 91-day and Rs 1,000 crore 364-day Treasury Bills under the market stabilisation scheme. Since there was enough liquidity in the market, both issues sailed through comfortably. Though the daily average subscription to RBI's 7-day repo auction fell by 22 per cent compared to the previous week to Rs 13,596 crore, the total outstanding amount at the RBI window (both 7- and 14-day repo combined) stood at a high Rs 73,500 crore on Friday. The call rate too remained the repo rate of 4.5 per cent.

The fear of an unstable government also had its impact on the domestic currency. The rupee lost 93 paise against the US dollar this week to close at nearly four-and-a-half month low of Rs 45.60/$ on Friday. Meanwhile, India's forex reserves rose to $118.58 billion in the week ended May 7 from $118.49 billion in the previous week.

Another major factor, which worried the bond markets, was the sharp rise in global oil prices. The Brent crude is hovering at its 13-year high of US$ 37.94 per barrel. This is already resulting in huge losses for the Indian oil companies, which may force the new government to raise domestic fuel prices, which in turn will lead to higher inflation. Thus, despite inflation falling to 4.2 per cent for the week ended May 1, 2004 from 4.26 per cent in the previous week, it failed to make any impact on the market sentiment.

Outlook
All eyes will be set at Tuesday's (May 18) RBI Annual Policy Statement, where the RBI governor will put forward his view on the domestic interest rate. Though the market is not expecting any major alteration in the interest rate, inflation is expected to rise amid pressure from high global oil prices. RBI may give up its three-year long soft interest rate bias. That apart, the formation of a new government will be the much-tracked event of the week.