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RBI’s ‘Baby Steps’ Instead of ‘Big Leap’ Favoured the Bond Market

Highlights:

• RBI announced policy rates; Repo, Reverse Repo and CRR rose to 5.25 percent, 3.75 percent and 6 percent respectively, up by 25 bps.

• RBI followed “baby steps” instead of “giant leap” as part of easing accommodation measures

• RBI’s M3 growth, Deposit Growth and Credit withdrawal projected at 17 per cent, 18 per cent and 20 per cent respectively for Fiscal Year 2010-11

• CRR hike of 25 bps wiped out Rs. 12,500 crore from the system; liquidity still plentiful with a weekly average of over Rs. 48,000 crores

• Bond Markets reacted positively to RBI announcements; Yields moved downward. Benchmark G-Sec 6.35% 2020 settled at 8.06 percent or Rs. 88.64; Introduction of new security G-Sec 8.20% 2022

• Bond Markets remained buoyant throughout the week after RBI’s announcement on policy rates.

• Inflationary pressures (food including non-food) and overseas signals such as US Treasury Yields and crude oil prices can also affect domestic bond yields.

View & Recommendation:

The policy rate hike is unlikely to make any major impact on short-term yields due to abundant liquidity in the system. The high steepness at the shorter end (1-5 years) of the yield curve can encourage fund managers to lower yields to generate extra returns as long as the yield curve does not move significantly. Liquid Funds and Ultra Short Term Bond Fund will continue to be preferred for investors having an investment horizon of 1-3 months and 3-9 months respectively. Investors should avoid investing in high average maturity funds and should limit investments to funds having average maturity up to 1 year. A Short Income Fund will fill the void in this category.

A Broader Perspective:

The bond markets reacted positively to RBI’s Annual Policy for Fiscal Year 2010-11. The RBI’s calibrated approach in exiting accommodative measures announced during the crisis period of 2008 and early 2009 was welcomed by traders when RBI announced a 25 bps hike each in CRR, Repo Rate and Reverse Repo Rate, lower than the market expectations of 50bps . The RBI seemed more concerned about Inflation front and consequently shifted its actions to inflation-led, thus, giving a balanced approach to Growth-Inflation dynamics.

However, the markets could not cheer during the later part of the week and yields moved north across the curve in the following days. High Inflationary pressure, large weekly gilts supply including foreign signals such as US Treasury Yields and Crude Oil Prices continued to weigh on the gold prices. However, the better than expected 3G auction sentiments (The government hopes to collect Rs. 50,000 crore from its expectation of Rs. 35,000 crore), a positive MET forecast of normal monsoons and lower than expected net borrowings (25,000 crore net of Rs. redemptions) in the month of May can keep the feelings positive.

During the week, the benchmark G-Sec 6.35% 2020 lost its significance and reported very thin volume as it was replaced by G-Sec 8.20% 2022 amid expectations that the RBI will announce a new benchmark next month. The 10-year 6.35% 2020 and 8.20% 2022 yields moved lower. While the benchmark yield settled at 8.06 percent, 2 bps lower than the previous week’s close, the new G-Sec 8.20% 2022 has lost 16 bps since its inception. Traders feared that 6.35% 2020 supply would either shrink or stop and volume shifted to G-Sec 8.20% 2022. Apart from this, the RBI successfully auctioned bonds worth Rs. 12,000 crore – the 7.02% 2016 for Rs. 6,000 crore, the 8.26% 2027 for Rs. 3,000 crore and the 2020 Floating Rate Bond for Rs. 3,000 crores. The RBI sold its first floating bond in this fiscal year 2010-11. Floating rate bonds are preferred by investors because the coupon is adjusted every six months, allowing them to avoid booking nominal losses on their books. The RBI also announced that it would announce gold bullion auction results on the following Monday of auction week instead of Friday of the same week.

Liquidity as measured by bids for reverse repo/repo under Liquidity Adjustment Facility was comfortable with bids averaging Rs. 48,738 crores. The coming week may see a slight contraction in liquidity after Rs. 12,500 being drained as part of increase in CRR.

Corporate bonds also saw their credit spreads narrow. Five- and Ten-year spreads fell by 18 bps and 10 bps to 52 bps and 53 bps respectively. The 10-year Corporate Bond yield closed at 8.75 percent, a loss of 12 bps.

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