Reflexes:
• RBI announced policy rate hikes; Repo, Reverse Repo and CRR increased to 5.25 percent, 3.75 percent and 6 percent respectively, an increase of 25 bps
• RBI followed “baby steps” instead of “great leap” as part of accommodative decommissioning measures
• M3 RBI growth, deposit growth and loan withdrawals are projected at 17%, 18% and 20%, respectively, for FY2010-11
• CRR increase of 25 bps drained Rs 12,500 crore from the system; liquidity still abundant with weekly average above Rs 48,000 crore
• Bond markets reacted positively to the RBI announcements; Yields fell. Benchmark G-Sec 6.35% 2020 settled at 8.06% or Rs 88.64; Introduction of new security G-Sec 8.20% 2022
• Bond markets remained buoyant throughout the week following the RBI’s announcement of policy rate hikes.
• Inflationary pressures (food and non-food) and foreign signals, such as US Treasury yields and crude oil prices, can also influence domestic bond yields.
View and recommendation:
The increase in the policy rate is unlikely to have a large impact on short-term yields due to the abundance of liquidity in the system. The large slope at the shorter end (1-5 years) of the yield curve may prompt fund managers to cut yields to generate additional returns as long as the yield curve does not move significantly. Liquid funds and very short-term fixed-income funds will continue to be preferred by investors with an investment horizon of 1 to 3 months and 3 to 9 months, respectively. Investors should avoid investing in high average maturity funds and should restrict investments to funds that have an average maturity of up to 1 year. The short-term income fund will fill the gap in this category.
Broader Perspective:
Bond markets reacted positively to RBI’s annual policy for the 2010-11 fiscal year. The RBI’s calibrated approach to exiting the accommodative measures announced during the crisis period of 2008 and early 2009 was welcomed by traders as RBI announced a 25bp increase each in CRR, Repo Rate and Reverse Repo Rate. , below market expectations of 50 bps. The RBI seemed more concerned with the inflation front and consequently changed its actions to inflation-led, thus taking a balanced approach to growth-inflation dynamics.
However, markets were unable to cheer up the latter part of the week and yields moved north along the curve in the following days. High inflationary pressure, the large supply of gilts week after week, including foreign signals such as US Treasury yields and crude oil prices, have continued to weigh on gilt prices. However, better-than-expected 3G auction sentiments (government expects to raise Rs 50 crore than expected of Rs 35 crore), positive MET forecast of normal monsoons and lower-than-expected net lending (Rs 25 crore net of redemptions) in the month of May may keep the sentiments positive.
Over the week, the benchmark G-Sec 6.35% 2020 lost its significance and reported very low volume as it was replaced by G-Sec 8.20% 2022 amid expectations that the RBI will announce a new benchmark next month. 10-year yields of 6.35% in 2020 and 8.20% in 2022 were down. While the benchmark yield stood at 8.06%, down 2 bps from the previous week’s close, the new G-Sec 8.20% 2022 lost 16 bps since its launch. Traders feared that the 6.35% supply in 2020 would be reduced or stopped and the volume changed to G-Sec 8.20% in 2022. Apart from this, the RBI successfully auctioned Rs 12,000 crore worth of bonds : 2016 7.02% for Rs 6,000 crore, 2027 8.26% for Rs 3,000 crore and 2020 floating rate bond for Rs 3,000 crore. The RBI sold its first floating rate bond in this fiscal year 2010-11. Investors prefer floating-rate bonds because the coupon adjusts every six months, allowing them to avoid recording nominal losses on their books. The RBI also announced that it would announce the results of the gilt auction on the Monday following the auction week instead of the Friday of the same week.
Liquidity, as measured by reverse repo/repo offers under the Liquidity Adjustment Facility, felt comfortable with offers averaging Rs 48,738 crore. Next week may see a slight contraction in liquidity after Rs 12,500 was drained as part of the CRR surge.
Corporate bonds also saw their credit spreads narrow. Five-year and ten-year spreads fell 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.