C. Shivkumar

BONDS weakened last week as traders preferred to be cautious on account of soaring international oil prices and buoyant credit offtake.

Traders said that insurers continued to be active. Faced with a paucity of high-coupon securities, insurers were no longer finicky about picking up securities with tenors in excess of 10 years, traders said.

Low-tenor papers: In fact, some of the insurers were picking up securities with maturities as low as 2008.

Also, mutual funds/unit-linked insurance funds were also buying bonds.

As a result, traders said that even if there was any impact of oil companies' credit demand, insurers/mutual fund purchase prevented a steep drop in prices.

Yet, international oil prices continued to be a major worrying factor. International oil prices had topped $60 a barrel. At these prices, the weighted average costs for domestic refiners were close to about $54 barrel. Currently, Indian imports are about two million barrels per day, or an oil bill equivalent to $108 million.

Slowdown in institutional inflows was also a cause for worry. Daily current account inflows are lower than the oil bill.

Current account deficit: Consequently, there was a fear that there could be large current account deficit in the coming months. Most bankers said that the export pick-up during the second half and a possible retreat in oil prices would somewhat correct the situation.

This worry reflected in the RBI's mop-up through reverse repos. The mop-up towards the weekend tapered off to less than Rs 5,000 crore.

For the first time, some of the banks took recourse to the repo window, where the RBI provides liquidity support of close to Rs 1,000 crore at the bank rate of six per cent.

Interest rate volatility: Besides, fear of interest rate volatility prompted some of the bankers to remain liquid. As a result, during last week's Treasury bill auction, the yields on the 91-day T-bill hardened to 5.37 per cent, from 5.32 per cent the previous week. Yield on the 182 T-bill was 5.67 per cent, up 27 basis points from the previous auction.

Despite this tightening at the short end, the weighted average 10-year yield to maturity (YTM) hardened slightly to 7.06 per cent last week, up from the previous week's level of 7.03 per cent.

Tax collections: Traders said what also caused the hardening last week was large advance tax payments. Estimates are that this year's advance collections are the highest.

As a result, tightening in liquidity was seen as a temporary one, bankers said.

"Markets are surfeit with liquidity and this is only a temporary situation," said Mr B. Swaminathan, Executive Director of Canara Bank.

One reason for this optimism was the shrinking spreads between one year and 23 years. This spread was 158 basis points last week, down slightly from 160 basis points the previous week. Spreads usually tend to shrink when the outlook is positive.

Daily trading volumes increased to about Rs 3,800 crore. Further, with inflation down to 4.1 per cent, real yields for one year are at 1.6 per cent, well within the internationally accepted levels.

Rally expected: Consequently, there were signs that the markets could be poised for a potential rally.

Anticipation was that the rally would begin once the tax refunds start, as liquidity would improve.

Last week, some of the insurers have liquidated their holdings of equities and are expected to purchase bonds at high YTMs.

Fed rate hike: Last week's moves by the US Federal Reserve to hike the funds rate to 3.25 per cent was also expected to contribute to a liquidity tightening. The Fed also hiked the discount rate by 25 basis points to 4.25 per cent (The rate at which member banks borrow short-term funds directly from a Federal Reserve bank).

The Fed's move triggered flows of non-debt capital out of the country, because some had already pared their holdings in Indian investments during the last two weeks anticipating the hike in rates.

Forex reserves: This reflected in the reduction in the foreign exchange reserves by $676 million.

During the last few weeks, there were outflows for prepayments also, bankers said. The reason for this prepayment was that the Fed rate hike has narrowed the gap between Indian and US interest rates. For instance, the difference between the US discount rate and the RBI's bank rate was only 1.75 per cent. That has given hedge funds to remain out of Indian debt investments at least for the time being, and stay locked into US investments.

Govt borrowings: Besides, government borrowings, so far, have been slow. Since the beginning of this fiscal, the government has raised Rs 42,000 crore through dated securities. The target for the current year is Rs 1.22 lakh crore, implying that large volumes of the borrowings were likely to be carried over into the second half.

If tax collections remain buoyant, the government is likely to reduce its borrowings.

So far, however, indications were not positive, traders said. This was despite the buoyancy in advance tax collections. Other tax collections, direct and indirect, have remained slack.

Credit offtake: Further, credit offtake during the year has remained buoyant, especially in retail. Incremental credit-deposit ratios for most banks continue to be close to 100 per cent. The reason being that most of the bankers were funding credit growth by selling investment and some were even prepared to book notional losses in the process to improve earnings from credit.

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