The bond market bid and “got given” at higher levels of yields in the first government bond auction of the second half of fiscal 2011-12. The government auctioned Rs 15,000 crores of bonds last week and the cut off yields on the bonds auctioned were at the highest levels seen during the week. The bonds auctioned were the 8.07% 2017 bond for Rs 3000 crores, the 8.08% 2022 bond for Rs 6000 crores, the 8.28% 2027 bond for Rs 3000 crores and the 8.30% 2040 bond for Rs 3000 crores. The cut offs came in at 8.64%, 8.70%, 8.87% and 8.92% respectively. Bond yields closed at higher than cut off levels post the auction results leading to week on week rise in bond yields between 20bps to 33bps across the yield curve. The auction was fully subscribed, with Rs 898 crores or 6% of the total auction size, devolving on Primary Dealers (PDs). PDs had fully underwritten the bond auction and the RBI received Rs 27,410 crores of competitive bids for the full auction, a bid to cover ratio of 1.87 times.
The fact that the RBI fully cleared the auctions at higher levels of yields without devolving a larger amount of bonds on PDs indicate that the central bank and the government are fine with paying higher yields in the auctions. The increase of Rs 53,000 crores in the total borrowing of the government for the second half of fiscal 2011-12 shows slippages in government finances and the price for the slippage is higher yields. The markets will take the higher cut offs as a cue to bid at higher levels of yields in the forthcoming auctions, thereby testing the RBI and the government’s tolerance to rising yields.
The Rs 15,000 crore auction saw reasonable demand with bids at 1.87 times the auction size indicating that demand is not an issue. There is demand at higher levels of yields and the market is forcing the government to pay a higher price for budget slippages. The market is also concerned with the status of current bonds in auction as many of them including the ten year benchmark bond, the 7.80% 2021 bond have outstanding issuances that are close to single issuer outstanding limit of Rs 75,000 crores.
The bond market believes that the current bonds in auction will become illiquid soon with new bonds coming up for auction and is bidding defensively for the bonds. This defensive bidding will continue until the RBI starts issuer new bonds that will be perceived as more liquid than the older bonds. Once new bonds are issued, markets will bid more aggressively for the auctions leading to a fall in bond yields from higher levels.
The government bond yield curve steepened in the auction with the five over thirty spread moving up from levels of 20bps pre auction to 30bps post auctions. The steepening of the curve suggest that investor interest is low for longer dated bonds and until investors come back into the market lured by higher yields, traders will steepen the yield curve by bidding at higher levels of yields in long dated bonds.
Corporate bond yields did not rise as much as government bond yields as improving liquidity kept yields from rising up too sharply. Five and ten year benchmark AAA corporate bond yields rose by seven and ten basis points respectively week on week. Five and ten year credit spreads fell by 12bps each to close at 84bps levels respectively. Credit spreads are more likely to move on government bond yield movements than movements in corporate bond yields.
Interest rate swaps saw a flattening of the yield curve with the five over one OIS (Overnight Index Swaps) spread coming off from levels of negative 80bps to negative 65bps levels. The swap curve is likely to continue on its flattening trend as the market pays five year OIS yields on worries of government bond yields moving up while the one year OIS yield is likely to remain stable as it starts factoring in a status quo on policy rates by the RBI
Liquidity improved in the system on the back of government spending and half year end money held by banks coming back into the system. Bids for reverse repo at 7.25% averaged Rs 16000 crores on a daily basis while bids for repo at 8.25% averaged Rs 11,000 crores last week. Liquidity in the system should move with a negative bias as busy season and festive demand for cash picks up.