Quarterly Debt Update
The market is expected to remain cautious with a slight southward bias in yields
The debt market has witnessed one of the best times and for the second year in succession yields have continued to remain soft, causing huge price appreciation of bond portfolios. The previous year 2001 had seen a near 300 per cent fall in interest rates of 10-year paper and it was expected that 2002 might not be as good and players were turning cautious at the start of the year.
The start of 2002 was marked by jitters and fear of war on account of the attack on Indian Parliament in December, 2001. However, ebbing war fears, and favourable market conditions have kept the yields soft. The year 2002 has seen a drop in 10-year yields by nearly 150-160 basis points.
One of the major propellants was the liquidity in the system. In its efforts to prop the rupee and help exporters, the central bank has been purchasing dollars leading to a ballooning of our forex reserves. Forex reserves have gone up from US $48 bn at start of the year to US $68 bn as on Dec 15, 2002, a $20 bn dollar accretion amounting to infusion of roughly Rs 96,000 crore during the calendar year. This coupled with M3 (broad money) growth of over 13 per cent and low credit offtake has resulted in such abundance of money in the system that interest rates have been forced to remain soft.
With a view to spurring consumer demand, special sops were given to the housing finance sector and tax incentives on housing loans were put forth during the budget, but this has not affected supply. Another major cause for optimism in India's economy is the external environment of excess capacity and global recession.
The US Fed rate has been brought down to 1.25 per cent. A worrying factor on the global front is the US stand on war with Iraq. The crude oil price has also shot up to touch a two-year high of nearly $33 per barrel. Weakening of the dollar against most major currencies led to a shift of dollar assets to other assets. The burgeoning dollar reserves in India, the strong rupee and higher interest rates caught the attention of avid investors. This has led to a surge in NRI deposits in the last few months. This additional flow of funds to the existing abundance in the system forced interest rates to remain soft.
Highlights of the last quarter
* RBI governer Bimal Jalan's "Triple Treat" in the mid-term review of the Monetary and Credit policy sent the debt market to a frenzy.
* Gilt and corporate paper yields witnessed lifetime lows in a system awash with liquidity.
* 10-year benchmark yield on sovereign paper neared the psychological mark of 6.00 per cent.
The major events in the quarter have been the credit policy announcements, the Fed rate cut and a strong rally in debt markets due to abundant liquidity. Effective Wednesday October 30, 2002, the RBI governor announced a cut in the bank rate and repo auction cutoff rate to 6.25 per cent and 5.50 per cent respectively. The bank rate, at 6.25 per cent is at its lowest since 1973. The central bank said from November 16, 2002, banks would have to maintain a cash reserve ratio of 4.75 per cent instead of 5.00 per cent.
Though the market was expecting a softening of the bank rate and repo rate, the CRR cut by 25 basis points is what surprised the market. This move meant the automatic release of nearly Rs 30 billion into a system already flooded with liquidity. The gilt market reacted positively to this move by the central bank and a bullish rally was set leading to volumes touching Rs 72 billion in the SLR segment.
Overall, the month of November was favourable for debt markets both from the domestic and external environment.
The liquidity infusion through CRR cuts during the credit policy took effect on November 16. The surge in NRI deposits in the last few months due to the weakening of the dollar against most major currencies, the burgeoning dollar reserves in India, the strong rupee and higher interest rates added to the liquidity and led to downward movement of yields.
The favourable external environment further accelerated this when the Fed cut its interest rate by 50-bps to 1.25 per cent. However, gilts shed some of the gains as concerns that the central bank would absorb liquidity through open market bond sales, to stem the slide in yields, triggered intermittent profit sales.
In the absence of any event risk debt funds and debt markets continued to witness a favourable environment for the month of December. A signal of caution was given by the central bank when it announced a change in the amount and method of the auction from the uniform bidding method to the multiple auction method in the case of the 91-day T-Bill. The move clearly reflected RBI's desire to gauge and control liquidity in the system and prevent any speculative driving down of interest rates.
During the quarter, the RBI issued draft guidelines on anonymous screen-based order-driven trading in government securities on stock exchanges. This is a step forward towards the Real-Time Gross Settlement system (RTGS) that is envisaged for the future. Towards this, the RBI initiated demats of bonds and trading on the Negotiated Dealing System (NDS). We expect all these measures to help better price discovery and add depth to the debt markets.
Outlook
Every time the yields in debt market have fallen this quarter it has been felt that these are the lowest levels to which they can go, and every time they continued to slide further. The triple rate cut announced by the RBI governor Bimal Jalan, excess liquidity in the banking system and a softer rate regime voiced by the finance minister and the RBI governor, have ensured that yields continue on their southern sojourn.
The domestic economic environment is experiencing positive signals in the form of a benign inflation rate, burgeoning forex reserves and a stable political environment; all of which are positive. However, the external environment does have a few issues, which could have a major impact on the sentiments of participants in the debt market. The more prominent among these is a spurt in crude prices on account of war clouds over Iraq and a flagging US economy.
Overall, we expect short-term rates in the gilt segment to see some downward correction at the start of the year. With comfortable liquidity, and the likelihood of a sudden jump in non-food credit offtake being remote, the market is expected to remain cautious with a slight southward bias in yields. In the corporate bond segment, keeping these positive signals in mind, we expect a stable-to-downward bias of yields and perceive a slight correction of spreads between gilt, AAA and lower-rated papers.
Sharpe points
An analaysis based on Sharpe ratio, a measure of a security
