Bond markets are becoming unduly bullish on long bonds i.e. bonds of maturities of over fifteen years. The bullishness on long bonds has brought down spreads between the ten year benchmark government bond and bonds of maturity of over fifteen years. The spread between the 8.15% 2022 bond and the 8.97% 2030 bond is at levels of 26bps while the spread between the 8.20% 2022 bond and the 8.83% 2041 bond is at 36bps. The spreads have compressed by 7bps to 10bps post the release of the government-borrowing calendar for second half of fiscal 2012-13. Markets have to question the premise on which it is buying long bonds, as the logic it is giving to the spread compression does not have sound fundamentals behind it.
The logic the market is giving in favor of long bonds is as follows. The government borrowing calendar for the period October 2012 to April 2013 places the issuance of bonds of fifteen years and above at 24% of the total borrowing of Rs 200,000 crores (assuming that Rs 3000 crores is raised in every auction). Issuance of bonds of less than ten years of maturity is around 34% of total issuance assuming Rs 4000 crores is raised in every auction and issuance of bonds in the ten to fourteen years of maturity bucket forms 44% of total issuance.
The equation could change if the government issues Rs 2000 crores of long bonds and Rs 3000 crores of less than ten year maturity bonds in every auction. Long bond issuances will then account for only 16% of total auction amount of Rs 200,000 crores while below ten year maturity bonds will account for 24% of total auction size. The ten to fourteen year maturity buckets will then account for 60% of total auction size.
The bond market in its infinite wisdom is starting to believe that there will be a demand supply gap in long bonds where demand from investors will far exceed the supply leading to aggressive bidding in the auctions. Markets are playing for lower auction cut offs in terms of yields for bring down long bond spreads.
The market logic in bringing down long bond spreads has two serious flaws. The first flaw is that there will be good demand for long bonds at compressed spreads. Banks do not buy long bonds as it hurts the maturity profile of their portfolio. Traders are wary of long bonds and if they see some weakness in demand at compressed spreads, they will shun the bonds leading to high impact cost of exit. Investors such as insurance companies and provident funds may allocate fewer funds to long bonds if they view the spread compression as overdone.
The second flaw is that by arguing for a demand supply gap in long bonds, the markets are also arguing that demand for on the run bonds including the benchmark ten year bond will fall. The only reason demand for on the run bonds falling is that RBI may not cut rates sharply given sticky inflation and that the government will come and borrow more post January 2013. If this reason is true then long bond yields will have to rise on negative interest rate factors.
The supply factor will also keep yields pressured if fundamental factors of lower interest rates including rate cuts, falling inflation and stable fiscal deficit are negative. State government borrowing of Rs 55,000 crores to Rs 60,000 crores in the October to December 2012 period accompanies government borrowing. Long bond investors may prefer state development loans that give higher yield over long government bonds leading to lower demand for long maturity bonds in the auction
Markets should first get comfortable on the ten year segment of the yield curve before taking down long bond spreads.
Corporate bond yields in the five and ten year benchmark AAA bond fell last week on the back of heavy investor demand. Five year and ten year AAA corporate bond spreads fell by 10bps and 7bps respectively to close at ten month lows. The narrowing of credit spreads indicate better outlook on liquidity, interest rates and credit quality. Opportunistic supply by corporates will push up credit spreads from current levels.
OIS (Overnight Index swaps) yield curve fell on the back of better sentiments on government bonds. One and five year OIS yields fell 10bps each to close at levels of 7.61% and 7.06% respectively. OIS yields are likely to move in a narrow range from current levels given that the curve is factoring in rate cuts ahead.
Liquidity as defined by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI tightened marginally last week. Bids for repo averaged Rs 72,400 crores on a daily basis last week against an average of Rs 71,000 crores seen in the week before last. Liquidity tightened on account of September end demand for funds. Liquidity will ease in the coming weeks on the back of government spending and banks releasing liquidity in October.
Government bond auctions
The government auctioned Rs 15,000 crores of bonds last week. The bonds auctioned were the 8.07% 2017 bond for Rs 4000 crores, the 8.33% 2026 for Rs 6000 crores, the 8.97% 2030 bond for Rs 3000 crores and the 8.83% 2036 bond for Rs 2000 crores. The cut offs came in at 8.18%, 8.23%, 8.42% and 8.46% respectively. The government is scheduled to auction Rs 13,000 crores of bonds this week.