The RBI chose to devolve 40% of the total auction size of the 7.83% 2018 and 7.80% 2021 government bonds on to the primary dealers (PD’s). The notified amount of the 7.83% 2018 bond auction was Rs 4000 crores and the PD’s were forced to take Rs 1614 crores at the cut off yield of 8.79%. The notified amount of the 7.80% 2021 bond auction was Rs 6000 crores and the PD’s took Rs 2424 crores of the bonds on to their books at the cut off yield of 8.78%. PD’s fully underwrite the government bond auctions, for which they receive underwriting commissions. Given that bond auctions usually go through without large scale devolvements, PD’s underwriting commissions are extremely low, sometimes even below 0.01%. PD’s bid for underwriting commissions, and until the latest devolvement, the bids have come in at very low levels. The last auction saw PD’s bid at Rs 0.0393 for the 7.83% 2018 bond and Rs 0.0243 for the 7.80% 2021 bond. The bids are per Rs 100 and the underwriting commissions works out to below half a basis point in terms of yields.
The low underwriting commissions fail to protect PD’s if auctions are devolved on to them. PD’s stuck with 7.83% 2018 and 7.80% 2021 bonds at cut off yields of 8.79% and 8.78% respectively have to either hold the bonds for better levels to sell or sell at distress levels in order to make space for the next round of government bond auction. Hedging tools are limited to a few PD’s who have positions on interest rates swaps on the government bond yield curve (known as INBMK swaps). The overnight index swap (OIS) is an imperfect hedge as correlation between OIS and government bond yields have a tendency to break down completely in the very near term.
PD’s will have to start bidding for higher underwriting commissions. The risk of devolvement is high in the current uncertain environment in interest rates given inflation at 9.72% while the government does not have funds and requires to borrow from the markets. The higher the underwriting commissions the more protection against losses on devolvement.
This week is a packed week in terms of issuances, despite the lack of a government bond auction. State governments are scheduled to auction Rs 7585 crores of state development loans (SDL’s), while the government is issuing cash management bills for Rs 10,000 crores. Government finances are in the red with the overdraft with the RBI at over Rs 38,000 crores against the limit of Rs 20,000 crores. The weekly treasury bills auction of Rs 8000 crores is as per the schedule given in the Treasury bill issuance calendar for the second half of fiscal 2011-12. The next government bond auction is scheduled for the 28th of October 2011 and PD’s will have that much more time to offload bond positions. However given packed issuances this week and RBI policy review next week, PD’s will find it difficult to sell bonds at better levels of yields.
The bond market had mixed news last week. IIP (Index of Industrial Production) growth for August 2011 came in weaker than expected at 4.1% taking the April –August 2011 growth to 5.8% against 7.8% growth seen in the same period in 2010. Inflation as measured by the WPI (Wholesale Price Index) came in at 9.72% for the month of September 2011, the fifth straight month of over 9% levels. The markets will speculate on whether RBI will look at growth deterioration or high inflation in the policy review on the 25th of October.
OIS yields went up sharply week on week on panic hedging by traders on the back of rising bond yields. One and five year OIS yields rose by 24bps and 18bps to close last week at 8.17% and 7.46% levels respectively. OIS yields will remain pressured until RBI policy review.
Corporate bond yields rose with five and ten year AAA bond yields rising by 7bps each to close at 9.74% levels respectively. Corporate bond yields will remain pressured on worries of liquidity and rising government bond yields.
Liquidity tightened last week on the back of fresh product covering by banks. Liquidity as measured by the bids for repo/reverse repo in the LAF (Liquidity Adjustment Facility) of the RBI saw bids for repo last week averaging Rs 47,000 crores on a daily average basis against a daily average of Rs 11,000 crores seen in the week previous to last. Liquidity is expected to remain tight on the back of festive season demand for money.