Monetary transmission of a different kind: Road map for borrowing success

Despite a 1 percentage point rate cut, bond yields have been rising, and the spread between government securities and SDL as well as corporate papers is widening

On August 26, at an auction of state government securities, called state development loans (SDLs), Maharashtra did not accept a single bid. Like many other states, it was in the market to raise Rs 4,000 crore through bonds maturing in four, eight, nine and 10 years. There were plenty of bids worth at least Rs 15,000 crore for its SDL, but the state didn’t want to pay the bidders’ asking rate.

 

This doesn’t happen often. The last time a state didn’t accept any bids at an SDL auction was on April 25, 2018. The state, again, was Maharashtra, and it had Andhra Pradesh, Odisha and Rajasthan for company. The four collectively wanted to raise Rs 5,500 crore, but did not accept any bids.

 

In last week’s SDL auction, the cut-off yield for a 10-year paper, floated by Rajasthan, was 7.49 per cent. That made the gap, known as spread in the bond market, between a 10-year government security and a comparable maturity SDL, 84 basis points, or bps. One bps is a hundredth of a percentage point.

 

The yields have been rising for all papers: Government securities, SDL and corporate bonds. And the spread between government security and SDL as well as corporate papers has been widening.

 

Media reports indicate that last week, at least two corporate entities – Housing and Urban Development Corporation Ltd (Hudco) and non-banking financial firm Bajaj Finance Ltd – dropped their plans to raise money from the public as the yields were higher than they expected.

 

Before we delve deep into the bond market scenario, here’s a background of this phenomenon.

 

Retail inflation in July rose 1.55 per cent, its slowest pace in eight years, staying below the Reserve Bank of India’s (RBI’s) target for the fifth month in a row. The central bank follows a flexible inflation target of 4 per cent with a 2 percentage point band on either side. Since January 2019, this is the first instance of retail inflation falling below the RBI’s target.

 

The RBI has cut the policy repo rate by 1 percentage point between February and June, from 6.5 per cent to 5.5 per cent.

 

The first phase of the central bank’s 1 percentage point cut in banks’ cash reserve ratio (CRR), which will release Rs 2.5 trillion into the system, will come into effect in the fortnight beginning September 6.

 

Ideally, against such a backdrop, bond yields should be falling, making treasury managers happy. But all you see are glum faces of bond dealers in treasury rooms. They are all busy cutting losses.

 

On August 26, the 10-year bond yield touched 6.65 per cent at intra-day trading before closing at 6.60 per cent – the highest this financial year. The last time we saw this level was March 26. That day, it rose to 6.645 per cent but again closed at 6.60 per cent.

 

Remember, in the last week of March, the policy rate was 6.25 per cent and the liquidity deficit in the system was around Rs 20,000 crore. The current policy rate is 5.5 per cent and, on August 26, the system had Rs 1.78 trillion liquidity surplus.

 

The RBI kicked off its rate-cut cycle in February, and followed it up in April and June before pressing pause in August. On the first two occasions, it had cut the rate by 25 bps each, and in June, by 50 bps.

 

There are other interesting data points. While the 10-year yield has been on the rise, yields of short-term treasury bills have been declining. Let’s look at the trend on March 26 and August 26.

 

On March 26, both 91-day and 180-day treasury bill yield was 6.52 per cent each, while the 364-day yield was 6.47 per cent. On August 26, 91-day treasury bill yield dropped to 5.484 per cent, 180-day to 5.575 per cent and 364-day to 5.60 per cent. Overnight, the interbank call money rate, which was 6.31 per cent on March 26, dropped to 5.49 per cent on August 26.

 

In other words, the transmission of the policy rate cut is felt in short-term but not in long-term bonds. In bond market parlance, this is called bear steepening – a situation when long-term interest rates rise faster than short-term rates, causing the yield curve to widen.

 

On June 6, the last round of the rate cut, the price of the 10-year paper hit Rs 101.64 before closing at Rs 100.67. On August 26, its price dropped to Rs 97.77. Yields and bond prices move in opposite directions. So, now you know why bond dealers are looking glum.

 

The rise in long-term yield is one story. The other is the widening of spread between government securities and SDL as well as corporate bonds.

 

At the closing price on August 29, the spread between government securities and SDL and corporate bonds was 68 bps. On February 6, the day of the first rate cut in the current cycle, the spread between the government securities and SDL was 40 bps, and between government securities and corporate bonds, 55 bps. On June 6, the last rate cut, the spread between government securities and SDL was 42 bps, and between government securities and corporate bonds, 66 bps.

 

These figures point to an adverse demand-supply dynamics. While more bonds are up for sale, demand is tapering. Banks don’t see any incentive to buy bonds when the yields have been on the rise as the market perceives the rate cut cycle to be over.

 

Up to August 29, the Union government’s gross borrowing was Rs 6,38,000 crore against Rs 6,00,607 crore in the same period last financial year. When it comes to SDL, the borrowing so far this year has been Rs 3,79,310 crore against Rs 3,03,394 crore last year. A similar trend is seen in net borrowings.

 

This is at a time when some of the big pension funds are staying away from the bond market and diversifying into equities, with their regulations allowing them to invest 25 per cent of the corpus in equities instead of 15 per cent, which was until recently the norm.

 

One statistic succinctly illustrates the banks’ lack of excitement towards government bonds. In the current financial year, until August 8, the banking system has mobilised Rs 8,93,287 crore as deposits. During this period, banks have lent Rs 3,62,069 crore. How much have they invested in government securities? Barely Rs 51,536 crore. During the same period last year, this investment was Rs 2,22,255 crore.

 

Finally, what do all these figures tell? Governments – both central and state – have not benefitted from the 1 percentage rate cut. Corporations, which raise money from the market, too haven’t gained. The cost of borrowing has been rising for them. Of course, those who borrow from banks have got the benefit since loan rates linked to an external benchmark, such as repo rate or one-year treasury bill, have fallen. Many banks have also pared their marginal cost of fund-based lending rate.

 

I am sure the regulator has a plan to make the monetary transmission uniform and a success of the government borrowing programmes. Of course, the 7.8 per cent real gross domestic product (GDP) growth in the June quarter, after a 7.4 per cent growth in the previous three months, queers the pitch for any rate-cut hope. The market cannot grudge the change in stance in the June policy anymore.

The 7.8% real GDP growth in the June quarter, after a 7.4% growth in the previous 3 months, queers the pitch for any rate cut hope. The bond market can no longer grudge the June policy change in stance.

   

The writer is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in.  X: @TamalBandyo