Value buying by insurers keeps bond yields in check

Updated: May 16 2014, 10:53am hrs
With bond yields almost flat on a month-on-month basis in April, the markets entered the new fiscal with a lot of fear.

The prospect of resumption of large and regular weekly borrowings starting from the first week of April led to a massive spike in long-term bond yields. From a close of around 8.8% on March 28, 2014, the 10-year government bond yield rose more than 30 bps in four trading sessions to peak at 9.12%.

A spurt of value buying at those levels reversed the trajectory. By the middle of the month, rumours of RBI buying led bond yields even lower with the 10-year bond finally ending the month at 8.82%.

We have seen good buying demand from insurance companies and provident funds. This time, value buying by insurance companies and replacement demand from banks offered the key support. The extremely high bid-to-cover ratios, which is a measure of demand, at the first three auctions suggests that buying interest was very high among investors. As momentum grew stronger and yields moved lower, we saw traders and mutual funds also getting into action.

Foreigners, however, were sellers in April 2014. This, despite International Finance Corporation (IFC) buying around $200 million of 2020 bonds in the first week of April. IFC, an arm of the World Bank, began issuing rupee-denominated bonds in the global markets this year as part of its market development agenda.

This was the third tranche of its rupee global bond issue, capping its total issuance at $1 billion. Adjusted for this IFC purchase, FII banks have been net sellers in Indian government bonds, T-bills and corporate bonds of almost $2 billion.

This is much in contrast to the activity scene in the equity markets where markets have touched new daily highs in April with reasonably strong foreign flows. The trend suggests the challenges ahead for the bond market because of sticky inflation, the likelihood of El-Nino and a worsening fiscal deficit.

The rupee, however, buoyed by portfolio flows and positive sentiment, ended the month at around 60.5 despite a small-sell-off. Although intervention data comes with a lag, our liquidity model and market links are suggesting that Reserve Bank of India (RBI) has been steadily buying dollars from the markets. This is a good sign as building up forex reserves is crucial to impart continued stability to the rupee.

Building up forex reserves by buying dollars when the times are euphoric and flows are strong will provide the central bank with the much-needed arsenal to support the rupee post poll results. In fact, between 2010 and 2011, RBI's strategy of not buying forex reserves at a time when external debt was rising led to a lot of pain last year when the rupee sold off. So, with RBI now resuming the build-up of forex reserves, the markets would gain more confidence and ,thus, lower the chances of speculative attacks of the kind seen in August last year.

The RBI will try and protect the rupee from going below the 58-mark in the event of strong political outcome and, thus, add more to its forex reserves kitty. Its new consumer price index, inflation-based Real Effective Exchange Rate, a measure of relative currency value, is suggesting that, even at 60 against the dollar, the rupee is overvalued and, thus, necessitates the intervention on portfolio flows to keep it above that level to maintain relative trade competitiveness. The central bank thus far seems to be more active in the forwards to neutralise the impact of liquidity.

Murthy Nagarajan

The writer is head of fixed income at Quantum AMC