The bond market would have gone into RBI policy review next week on a positive note, but government finances put paid to any pre policy bullishness. The ten year benchmark government bond, the 7.80% 2021 bond saw yields close up by 4bps week on week on the back of the government advancing the Rs 10,000 auction scheduled for the week of 19th September to the week of 13th August. The government advanced the auction to bring down its overdraft with the RBI, which is running at over the Rs 30,000 crores limit.
The government borrows from the RBI through the WMA (Ways and Means Advances) facility for its funding requirements. The government is not allowed to borrow indiscriminately from the WMA facility and its limits are fixed at the beginning of the fiscal year. The WMA limit of the government for the period July to September 2011 is Rs 30,000 crores. This limits was breached in the beginning of July as the government had to fund a bond redemption of Rs 37,000 crores. The WMA utilization as of 15th July was Rs 39,000 crores. Cash management bills are auctioned to fund the excess overdraft.
The government is strapped for funds. It is overdrawn with the RBI despite auctioning Rs 12,000 crores of bonds on a weekly basis. Advance tax inflows in mid September can ease part of the funds crunch. Until then the government is resorting to auctions of bonds and cash management bills to bring down its overdraft with the RBI. The government is not increasing the size of its borrowing program for the first half of the fiscal, which offers some comfort to the market. However, it remains to be seen if fiscal slippages can be brought back in order.
The market is expecting a 25bps rate hike by the RBI in the policy review on the 26th of July. There is some optimism that this will be the last of the rate hike for a while. Market positioning is neutral (neither long nor short) into the policy. The market would have gone incrementally long into the policy if not for worries on government finances. A neutral positioning suggests that a rate hike with a pause signal will see bond yields rallying while a pause will cause a sharp short term rally.
The interest rates swap curve will start flattening if there is a pause in rate hikes. The five over one OIS (Overnight Index Swaps) spread is at negative 40bps with five year OIS yields at 7.58% levels and one year OIS yields at 7.98% levels. The spread is currently factoring more rate hikes ahead, hence a pause will bring down one year OIS yields much faster than five year OIS yields.
Corporate bond yields have fallen by around 25bps since the last policy rate hike in mid June. Five and ten year corporate bond yields are trading at around 9.38% levels from levels of 9.63% seen in mid June. Rates hikes with a pause signal will see corporate bond yields remaining stable while a pause will cause a sharp rally in corporate bonds yields in the short term.
Government bond auction
The government auctioned Rs 12,000 crores of bonds last week. The bonds auctioned were the 8.07% 2017 bond for Rs 4000 crores, the 8.08% 2022 bond for Rs 5000 crores and the 8.28% 2027 bond for Rs 3000 crores. The cut offs came in at 8.33%, 8.44%, and 8.62% respectively. The government is scheduled to auction Rs 12,000 crores of bonds this week.
The government auctioned cash management bills last week. The cut off on the 56 day cash management bill auction for Rs 6000 crores held on the 18th of July came in at 8.06% and the cut off on the 56 day cash management bill auction for Rs 4000 crores held on the 21st of July came in at 8.05%.