The Central and State Governments are set to borrow a total of around Rs 11 trillion in fiscal 2018-19. Central government gross borrowing is estimated at Rs 6.4 trillion (Read our note on Fiscal Deficit and Government Borrowing for 2018-19) while states could borrow a gross of Rs 4.6 trillion. Net of redemptions, Central Government borrowing would be Rs 4.3 trillion while State Government borrowing would be around Rs 3.8 trillion.
At a time when bond market sentiments are bad with 10 year government bond yields rising by 100bps from lows over the last 15 months, there is a big question mark on the absorption of this supply. Going by ownership pattern of government bonds and SDL’s, banks, insurance companies and provident funds would have to participate heavily in the auctions to absorb the supply. Chart 1 & 2. RBI too would have to step in to help borrowing go through smoothly.
Banks, the largest holders of government bonds, are holding bonds well in excess of their statutory requirement of 19.5% of NDTL. Banks holding of bonds are over 28% of NDTL. Post demonetization, banks have deployed excess liquidity in government bonds and also MSS bonds (outstanding of Rs 1 trillion). Banks have had to make provisions for notional losses in their books due to rise in bond yields and there is no appetite for taking more bonds on to their books. RBI making statements that banks should learn to manage their interest rate risk positions too has soured sentiments for banks.
Bank deposits too are not growing (4.45% growth as of 5th Jan 2018) as banks have cut rates on deposits due to liquidity infused through demonetization and RBI fx purchases. Hence banks have no incremental need to buy government bonds unless they see economic potential, which is not there given RBI’s inflation stance. If credit growth picks up, banks will prefer to deploy excess liquidity in credit.
Insurance companies and provident funds will continue to invest in government bonds and SDL’s given statutory requirements and also given that they would be seeing growth in assets as the economy grows. Over a period of a few years, this segment will become the largest holders of bonds.
FII’s have exhausted over 90% of limits in government bonds and unless there is a limit increase with a positive outlook for the INR, this segment will not be participating in the market actively. FII’s are still very reluctant buyers of SDL’s, utilizing under 20% of limits.
Mutual funds have been seeing outflows from their longer duration funds due to rise in yields and will not have appetite for bonds.
RBI, has been a net seller of bonds for Rs 1 trillion in fiscal 2017-18 as it sucked out excess liquidity through OMO sale auctions. RBI may be forced to buy bonds in 2018-19 if government borrowing has to go through smoothly, however this raises concerns on back door deficit financing, which is inflationary and goes against RBI inflation targeting mandate.
Bond markets will await budget numbers, work out the demand-supply maths before taking any directional positions in bonds.
The old 10 year benchmark government bond, the 6.79% 2027 bond, and saw yields rise by 1bps week on week to close at levels of 7.48% while the new benchmark 10 year bond, 7.17% 2028 bond, saw yields rise by 1bps to close at 7.30%. The on the run bond, the 6.79% 2029 bond saw yields close 2bps up at 7.48% levels and the 6.68% 2031 bond saw yields close up by 1bps at 7.58%. The long bond, the 7.06% 2046 bond saw yields close up by 1bps at levels of 7.67%. Gsec yields would trend up going into the budget.
The OIS market saw 5 year OIS yields closing 4 bps lower week on week at levels of 6.70%. The one year OIS yield closed down by 1 bps at 6.42%. OIS yield curve will steepen on the back of bond market worries.
Corporate bonds saw 5 year AAA corporate bond yields fell by 1bps at levels of 7.80% and 10 year AAA corporate bond yields fell by 1bps at 7.96%. Corporate bond yields will rise slower than government bond yields on the back of high system liquidity.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facility (MSF or Marginal Standing Facility) and MSS/CMB bond issuance was in surplus of Rs 808 billion as of 25th January 2018. The surplus was Rs 1335 billion as of 19th January.