OMO (Open Market Operations) purchase auctions will increase volatility in the bond markets. The first of the OMO auctions for Rs 10,000 crores is to be held on the 24th of November 2011. The RBI is holding bond purchase auctions in an effort to inject liquidity into the system. The market has been borrowing over Rs 100,000 crores in the LAF (Liquidity Adjustment Facility) window of the RBI on a daily average basis over the last couple of weeks. RBI believes that liquidity is becoming structurally tight and requires policy measures to ease liquidity in the system.
OMO’s have a three step process. The first step is the announcement of the bonds that the RBI is willing to purchase in the OMO auction. The second step is the bids by the market to tender bonds to the RBI in the auctions. The third step is the acceptance of the bids by the RBI. Each step of the OMO auction will have the market playing a guessing game, and this guessing game will impact bond yields in secondary market trading. The guessing game will also increase volatility in the market.
The RBI is likely to announce the bonds to be accepted for the OMO auction on the 22nd of November 2011. The market is already front running the bonds to be accepted in the auction by bring down yields of potential OMO candidates. The old benchmark ten year bond the 7.80% 2021 bond is a likely candidate for the auction as it has large floating stock. The bond went off the run just a couple of weeks back when the new ten year bond the 8.79% 2021 bond was issued. The outstanding on the bond is Rs 68,000 crores. The spread between 8.79% 2021 bond and 7.80% 2021 bond which was a negative 16bps a couple of weeks back has come off to 3bps post the OMO announcement. The 7.80% 2021 bond was trading at yields of 8.95% when the 8.79% 2021 bond was issued and is now trading at yields of 8.87% against the 8.84% yield on the 8.79% 2021 bond.
The other OMO bonds in contention include 7.17% 2015 bond and the 7.99% 2017 bond as these have been frequently auctioned this fiscal and have large outstanding amounts. If the RBI does put up the 7.80% 2021 bond for OMO auction the market will then look to bid i.e. tender the bonds to the RBI. However if the RBI does not put up the 7.80% 2021 bond for the auction, the yield on this bond will rise sharply as positions built up for tendering the bonds in the auction will be sold off.
The bidding for the OMO auction is important. The market will have to decide the right yields at which to tender the bonds for the auction. Players who have bought the 7.80% 2021 bond at yields of over 8.90% in the secondary market will tender the bonds at yields not very far from the last traded levels of 8.87%. Investors who hold the 7.80% 2021 bond at purchase yields of less than 8.50% (a large part of this bond was issued around yields of 8.25% to 8.45%) will look to tender the bonds at yields below 8.87%. The market will guess on where the bids are likely to occur and this guessing will again move bond yields in secondary market trading.
The third part of the OMO process is the RBI’s acceptance of bids. If the bids tendered by the market for the 7.80% 2021 bond is accepted by the RBI, the market will take this as a positive sign as it adds liquidity into the system and takes away some floating stock from the market. If the RBI does not accept the bids in the auction due to bids coming in way below traded levels of yields, it is negative for the market. Liquidity will continue to remain tight and players will be left with unsold bonds leading to spike in bond yields.
RBI by using OMO as a liquidity easing measure is actually increasing uncertainty in the market, as each part of the OMO process becomes a guessing game.
Government bond auctions
The government auctioned Rs 13,000 crores of bonds last week. The bonds auctioned were the 7.83% 2018 bond for Rs 4000 crores, the 8.79% 2021 bond for Rs 6000 crores and the 8.28% 2027 bond for Rs 3000 crores. The cut offs came in at 8.88%, 8.83% and 9.13% respectively. The RBI devolved Rs 1150 crores of the 8.79% 2021 bond on to the underwriters.