Credit spreads as defined by the difference between government and corporate bonds of similar maturity are extremely tight. Three, five and ten year benchmark AAA corporate bonds are trading at levels of 9.38%, 9.52% and 9.57% respectively while benchmark government bonds of similar maturities are trading at annualized yield levels of 9.06%, 9.04% and 9.08% levels respectively. Three, five and ten year AAA credit spreads are at levels of 32bps, 48bps and 51bps respectively. Credit spreads have come off by 10bps to 20bps across the curve over the last one month.
Credit spreads become even tighter if compared to non benchmark bonds. The benchmark five and ten year on the run government bonds are the 7.28% 2019 and the 8.83% 2023 bonds that are trading at annualized yields of 9.04% and 9.08%. In contrast, the 8.12% 2020 and the 7.16% 2023 bonds are trading at annualized yields of 9.20% and 9.34% respectively. The spread between corporate bonds of similar maturities are around 30bps to 35bps.
At the short end of the curve, the spread between one year treasury bill and one year certificate of deposits is just 15bps. This spread was at levels of 50bps last month.
State Development Loan (SDL) spreads are at around 50bps, coming off from levels of over 60bps last month.
Given tight credit spreads, why is the market not choosing to shift to government bonds instead? The reason is the heavy supply of bonds that is hitting the market. Government will auction Rs 840 billion of government bonds in May along with Rs 140 billion of weekly auctions of treasury bills and Rs 80 billion of fortnightly SDL auctions. The constant supply of bonds is forcing the market to invest in corporate bonds that are in less supply given the beginning of the fiscal year when all issuers are in the planning stages for the fiscal.
The fact that markets are comfortable investing in very low credit spreads indicates that the market does not foresee an uptick in government bond yields from current levels. Stability in government bond yields is vital for credit spreads to stay at low levels.
Tight credit spreads are an indication that government bond yields could fall going forward. If the market is comfortable with absolute levels of yields on corporate bonds and does not see any uptick in government bond yields, there will be a tendency to shift to government bonds as supply eases. The government borrowing eases from June onwards and with a new government in place and liquidity outlook more positive than negative, government bond yields could trend down.
The risk to government bond yields moving down as well as credit spreads staying tight is the new government increasing bond supply, monsoon failure pushing up inflation expectations and global liquidity drying up on Fed asset purchase taper.
OIS market saw the curve invert with one year OIS yield rising by 2bps and five year OIS yield falling by 3bps to close at levels of 8.62% and 8.45% levels respectively. The five over one OIS spread inverted by 5bps to close at 17bps levels. The curve inversion is surprising given that policy rates are not expected to move up and liquidity is comfortable in the system.
Liquidity tightened last week as banks covered products in the first week of the reporting fortnight. Banks borrowing from the RBI was at Rs 800 billion last week against levels of Rs 750 billion seen in the week previous to last. Liquidity is likely to stay at around current deficit levels with no great drivers for liquidity this week.