Friday Podcast 31st May 2013
Transcript of the Podcast
Hi this is your editor Arjun Parthasarathy speaking.
This Podcast topic is on “Negative Carry May affect Bidding for IIB”
The Government of India has announced the first issue of Inflation Indexed Bonds (IIB) since 1997. The bonds are to be issued for an amount of Rs 1000 crores through a competitive bidding process on the 4th of June. The maturity of the IIB is ten years. IIB issued by the government as part of its scheduled borrowing program carries all characteristics of a government bond including repo and SLR (Statutory Liquidity Ratio) status.
We have published a detailed note on IIB in the report “Your Guide to Inflation Indexed Bonds”, which is placed on our website. RBI has also put out an FAQ on IIB for public consumption on its website.
In this podcast I will focus on how the market is likely to view the IIB and what will be the likely cut off on yields.
The market will have to bid at “Real Yields” for IIB. Real Yield is Nominal Yield adjusted for WPI Inflation. The reference Nominal Yield is the yield on the current on the run ten year benchmark government bond, the 7.16% 2023 bond, which is trading at levels of 7.15%. The WPI rate the market will look at is the forward WPI rate. RBI’s forecast WPI for fiscal 2013-14 is 5.5%. The market, if it does use the RBI forecast rate, will use 5.5% as the forward WPI rate.
The Real Yield taking the 7.15% level on the ten year bond and the 5.5% WPI rate is 1.65%. Assuming that the cut off for the ten year IIB is 1.65% with par value at Rs 100, the holder of the IIB, if it’s a bank, will receive just around 1.85% of interest, assuming WPI trends at 5.5%. The banks funding cost for carrying the IIB in its books is 7.25%, which is the current repo rate. The bank is effectively earning a negative carry of 540bps by holding the IIB.
The bank can choose to sell the IIB after one year as the price would have risen by 5.5% given inflation rate but at funding cost of 7.25%, the bank earns nothing from the IIB. The bank is also taking a risk in WPI coming off leading to lower price appreciation and lower coupon payment. Liquidity risk is also high given that the government is planning to issue just Rs 15,000 crores of IIBs for the whole year.
Expected repo rate cuts or system liquidity turning surplus making the reverse repo rate that is 1% below the repo rate as the funding rate can bring down the funding cost of banks leading to negative carry coming down. Repo rate cuts can only happen if inflation outlook is benign and RBI will be comfortable with reverse repo being the reference funding rate only when it is comfortable on inflation expectations. Falling inflation expectations is negative for IIB.
The market will look at the negative carry when it bids for the IIB. Cut offs can come in at well over 2% levels unless the novelty factor brings down real yields.
Thank you for listening in. Have a good weekend.