The ten over thirty segment of the government bond yield curve has compressed to levels where the whole yield curve has to shift down for the levels to sustain. The spread between the benchmark ten year bond the 8.15% 2022 bond and the benchmark thirty year bond the 8.30% 2042 bonds is at levels of 14bps. The spread at the time of the issuance of the bond on the 28th of December 2012 was at 19bps and the spread one month ago was at 23bps. The market has chosen to aggressively bring down the yields on the thirty year bond in the belief that interest rates will fall going forward and long bonds give more bang for the buck in a falling interest rate scenario.
The 14bps difference in spreads between the ten and thirty year bond is extremely low given current inflation expectations. Inflation as measured by the WPI (Wholesale Price Index) is expected to come in at 7.40% for the month of December 2012 and is expected to trend to below 7% levels in March 2013. However given the increase in fuel prices by the government, inflation could trend higher post March 2013.
The ten over thirty spread was as high as 50bps a couple of years back as inflation was trending at levels of 9% and above. The sharp fall in the yield of the thirty year bond indicates that the markets are not worried on inflation and in fact expect inflation to come off going forward.
The low spread between the 8.15% 2022 bond and the other widely traded bonds in the fifteen to thirty year segment of the yield curve also indicates that the ten year bond is being given an illiquidity discount. The spread between the 8.15% 2022 bond and the 8.33% 2026 bond and the 8.97% 2030 bond is at 7bps and 13bps respectively. The 8.15% 2022 bond has a total outstanding amount of Rs 64,000 crores and at best another Rs 16,000 crores of the bonds issued will be issued. The bond market is giving the 8.15% 2022 bond an illiquidity discount and is treating it as an off the run bond.
The issuance of a new ten year bond will see cut off on the new bond coming in at 15bps lower than the current levels of 7.87% traded on the 8.15% 2022 bond. That would mean that the ten year bond should actually be trading at levels of around 7.72% and yield curve spreads should actually be calculated based on where a new ten year bond should trade. The 8.30% 2042 bond is trading at levels of 8.01% and spreads with a new ten year bond will be more reasonable at levels of around 25bps assuming that the yield comes down to levels of 7.95% when a new ten year bond is issued.
The fact that a fresh issuance of a new ten year bond will shift the yield curve down indicates that the bond market is highly positive on interest rates coming off. The market is comfortable with very low levels of the ten over thirty spread and will not worry even if the spread rises as the yield curve shifts down, The market will worry only when absolute levels of yield rise on the thirty year bond and that is not on the cards in the current environment.
The weak IIP (Index of Industrial Production) data for November 2012 has increased expectations of rate cuts in the RBI policy review on the 29th of January 2013. IIP growth for November 2012 came in at a negative 0.1% against 6% growth seen a year ago and against 8.2% growth seen in October 2012. April-November 2012 IIP growth stood at 1% indicating weak production trends. The forecast of vehicle sales growth for full year 2012-13 to 0%-1% growth for cars and 0%-2% growth for trucks by the industry body corroborates the weak IIP trends.
Liquidity eased last week on the back of government spending. Liquidity as measured by bids of repo in the LAF (Liquidity Adjustment Facility) auction of the RBI saw bids average at Rs 85,600 crores on a daily basis last week against an average of Rs 113,000 crores seen in the week before last. The government drew down its cash balances from levels of Rs 82,000 crores to Rs 20,000 crores in the first week of January 2013.
Corporate bond yields fell on the back of falling government bond yields. Five and ten year benchmark AAA bond yields fell by around 8bps week on week to close at levels of 8.70% and 8.73% respectively. Corporate bond yields are likely to fall further on expectations of rate cuts by the RBI.
OIS markets saw the market paying five year OIS on expectations that five year OIS and five year government bond spread will come off. The spread is currently at 67bps with five year OIS trading at 7.20% levels and five year government bond trading at 7.87% levels. The spread should come off further on the back of fall in yields on the five year government bond.