In our Fixed Income Risk & Strategy Workshop for Treasuries held on the 16th of February 2018 in Mumbai, one topic that was debated extensively was banks appetite for government bonds going forward. Banks participation in the government bond market is vital for the government borrowing program to go through smoothly, without disruptions in bond yields.
Banks, especially the PSU banks, are nursing a grouse against the RBI. The banks, already reeling under strict provisioning norms and surfacing of scams that are causing huge losses (latest is PNB’s Rs 110 billion scam), are also facing mark to market losses in their investment books.
As per our calculations, banks hold over Rs 11 trillion of bonds in their mark to market books (Table 1). RBI has told the banks that they have to manage the interest rate risk on their bond holdings and with 10 year gsec yields spiking by 130bps from lows over the last 15 months, banks are facing a large mark to market provisioning on their bond holdings that are not part of their Held to Maturity (HTM) portfolio.
Banks are asking the RBI how to manage the interest rate risk. Hedging bonds using derivatives is not feasible, as derivative market depth does not support large hedging positions. Given that the market lacks depth, banks coming to hedge their positions will sharply take up yields as banks will be shorting the markets.
Banks are also not able to sell their holdings, as there are no buyers that can absorb such a large supply of bonds. Many bonds are also illiquid as they have gone off the run. Hence banks may stay off the government bond market, letting bonds first mature and also deposits to grow to slowly lower their mark to market holdings.
The old 10 year benchmark government bond, the 6.79% 2027 bond, saw yields rise by 9bps week on week to close at levels of 7.74% while the new benchmark 10 year bond, the 7.17% 2028 bond, saw yields rise by 9bps to close at 7.58%. The on the run bond, the 6.79% 2029 bond saw yields close 7bps up at 7.69% levels and the 6.68% 2031 bond saw yields close up by 8bps at 7.83%. The long bond, the 7.06% 2046 bond saw yields close up 17bps at levels of 7.90%. Bond markets turned negative on the back of rise in US treasury yields and worries of banking system given scams emerging in banks.
The OIS market saw 5 year OIS yields closing flat week on week at levels of 6.83%. The one year OIS yield closed up by 1bps at 6.49%. OIS yields are factoring a long period of stable repo rate and high liquidity.
Corporate bonds saw 5 year AAA corporate bond yields close down by 1bps at levels of 7.84% and 10 year AAA corporate bond yields close up by 4bps at 8.16%. 5 year AAA spreads fell by 7bps at 33bps and 10 year AAA spreads fell by 3bps at 48 bps. Credit spreads will stay sticky at lower levels given stable repo rate and easy liquidity conditions.
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 819 billion as of 16th February 2018. The surplus was Rs 1124 billion as of 9th February. Rise in government cash balances brought down liquidity, which could stay down on advance tax outflows and year end demand for funds in March.