The bond market is factoring in a 25bps repo rate cut in the 3rd May 2013 RBI annual policy statement. A 25bps repo rate cut will bring down the overnight lending rate from 7.50% to 7.25%. The drop in overnight lending rates will also bring down yields at the short end of the government bond and corporate bond yield curve. The short end yields will fall faster than long end yields leading to a steepening of the yield curve. Yield curve steepening with short end rates falling is positive for short term bond funds as these funds primarily invest in short maturity securities.
The current shape of the government bond yield curve and corporate bond yield cure is almost flat. One year treasury bills are trading at levels of 7.50%, five year government bonds are trading at yields of 7.58%, ten year government bonds are trading at levels of 7.75% while thirty year government bonds are trading at yields of 7.94%. The difference between the one year treasury bill and thirty year government bond is just 44bps and this spread is likely to increase post repo rate cut. One year Treasury bill yields will fall below 7.25% levels as markets start factoring in more rate cuts going forward.
The corporate bond yield curve is also flat with one year CD (Certificate of Deposit) yields at 8.40% and five and ten year benchmark AAA corporate bond yields at 8.50% levels. One year CD yields will drop to below 8.20% levels post repo rate cut.
System liquidity continues to be in deficit mode with banks borrowing an average of Rs 95,000 crores from the RBI on a daily basis. Liquidity deficit is predominantly due to cash surplus of the government being parked with the RBI. The government, when it parks money with the RBI, takes the funds out of the banking system and banks are left with that much less funds leading to system liquidity tightening. There are talks of the government parking its cash surplus with banks instead of with the RBI and if these talks turn out into action then system liquidity will turn into surplus from negative.
Surplus system liquidity, if it does happen, is highly positive for short end yields. The banks, in a surplus liquidity environment, will be lending to the RBI instead of borrowing from it. RBI borrows funds from banks at the reverse repo rate, which is 100bps lower than the repo rate. Overnight rates will fall from 7.25% (assuming 25bps repo rate cut) to 6.25% and this fall in overnight rates will drive down yields in the one to five year segment of the yield curve. The longer end of the yield curve will also benefit from the fall in overnight rates but given that the yield curve is flat, the short end of the curve will benefit the most.
Corporate bond yields fell in tandem with government bond yields last week leading credit spreads staying flat. Five and ten year benchmark AAA credit spreads closed at levels of 81bps and 64bps respectively. Five year corporate bond yields are likely to fall faster than ten year corporate bond yields post a 25bps repo rate cut. Five year credit spreads have room to move down while ten year credit spreads have limited amount of space to come off.
OIS (Overnight Index Swaps) market saw the curve closing marginally down week on week. One year OIS yields closed down 3bps at 7.23% levels while five year OIS yields closed down 1bps at 6.98% levels. The five over one OIS spread is inverted at a negative 25bps, and this inversion will come off post a 25bps repo rate cut. One year OIS yields will fall much faster than five year OIS yields on expectations of more rate cuts ahead.