The bond market is really worried about the absorption of supply of government bonds in fiscal 2018-19. The government is scheduled to borrow a gross of Rs 6.05 trillion and net of Rs 4.62 trillion of dated government bonds. Banks, the largest segment of buyers of government bonds with a 40% share in total outstanding government bonds, could stay away from the market, leading to a big gap in demand – supply balance. If banks step away from the market, only RBI can fill in the gap and that could mean a minimum of Rs 1 trillion of bond buying required by the RBI.
Banks are holding bonds well in excess of statutory requirement of 19.5% of deposits, with over 28% of SLR holdings. Banks investments in government bonds have risen by 30% since demonetization in November 2016, at a time when 10 year benchmark government bond yields were at levels of below 6.5%. The 10 year bond yield is now at 7.5% and banks are staring at huge losses in their bond holdings. SBI provided for Rs 34 billion of mark to market losses in its books for the 3rd quarter of fiscal 2017-18.
Bank deposits too are not growing given a higher base on demonetization and low interest rates paid on deposits. Deposit growth was at 5.1% as of 19th January 2018 on a year on year basis. Banks have no incremental need to buy government bonds and they could well stay away from the bond market in fiscal 2018-19.
Bond markets will trade cautiously going into April 2018, when the new borrowing program commences. The market will position for carry given that RBI has signaled a long pause on rates and given that liquidity will be extremely comfortable.
Liquidity will stay easy in the system as the government front loads its spending starting April 2018. RBI outstanding forward USD position of over USD 30 billion is latent liquidity of over Rs 2 trillion. 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 1124 billion as of 9th February 2018. The surplus was Rs 1230 billion as of 2nd February.
The old 10 year benchmark government bond, the 6.79% 2027 bond, saw yields fall by 10bps week on week to close at levels of 7.65% while the new benchmark 10 year bond, the 7.17% 2028 bond, saw yields fall by 7bps to close at 7.49%. The on the run bond, the 6.79% 2029 bond saw yields close 7bps down at 7.62% levels and the 6.68% 2031 bond saw yields close down by 9bps at 7.75%. The long bond, the 7.06% 2046 bond saw yields close flat at levels of 7.73%. Bond markets will trade cautiously until fresh borrowing starts in April 2018.
The OIS market saw 5 year OIS yields closing 6bps lower week on week at levels of 6.83%. The one year OIS yield closed down by 7bps at 6.48%. OIS yield curve is trading below the gsec yield curve indicating that swap market is unwilling to take too much negative carry on shorts. OIS yields should trend down on RBI policy and liquidity expectations.
Corporate bonds saw 5 year AAA corporate bond yields close down by 9bps at levels of 7.83% and 10 year AAA corporate bond yields close down by 6bps at 8.12%. 5 year AAA spreads rose by 3bps at 40bps and 10 year AAA spreads rose by 7bps at 51 bps. Credit spreads will stay sticky at lower levels given stable repo rate and easy liquidity conditions.