Market hit by size of govt borrowings

Government's extraordinarily large additional borrowings have exaggerated bearish sentiments, feels Pradeep Madhav

    BOND houses have been adversely affected by the unprecedented volatility in money markets during the year. Although they briefly made money in the October-December quarter when global interest rates crashed, the last quarter has seen erosion in gains. In an interview with Mayur Shetty, STCI Primary Dealer MD Pradeep Madhav, one of the largest bond houses, explains why prospects for the coming year look even more bleak.

Mid-March has always been bad for the bond markets. Can you cite the reason for this phenomenon?
The financial year end being March, most domestic banks and institutions look to consolidate their portfolios with paring of positions and profit booking. Fresh positions are initiated only to fulfil statutory requirements. With most nationalised banks continuing to be surplus on SLR, there is limited appetite or incentive for increasing their bond books for the fear of any adverse movement in yields. Primary dealers also prefer to carry a relatively small position as their entire portfolio is mark to market. This year, bearish sentiments have been exaggerated by the extraordinarily large additional borrowing by the government in the last quarter.
What has changed between January and now for yields to rise by 200 bps?
In my opinion, it is the change of sentiments. The market has been numbed by the size and frequency of the government's borrowings. We have witnessed primary issuances of Rs 84,000 crore by the central government and Rs 59,529 crore by state governments in the last quarter (beginning January till date) of this financial year. This size of borrowing is absolutely unprecedented and almost equals 32% of the entire budgeted borrowing of FY08-09. The bond market simply does not have the appetite to absorb this kind of supply, especially after the reduction in SLR by 1% in November 2008. Although banking as well as the insurance sectors have seen a rise in investments in government securities, the mounting pressure on banks to push up credit (loans), limits the potential to hold increasingly larger amount of government securities. This has caused bond yields to rise, in spite of the liberal rate cuts by RBI. We now have 10-year bond yields reversed to the level, at which it was before the first reverse repo rate cut on December 6, 2008.
Why is the bond market bearish despite sharp fall in inflation and slowdown in credit?
Bond markets remain apprehensive about the impact of the fiscal profligacy of the government and the huge projected borrowing for the next financial year, with the possibility of further overshooting of the budgeted fiscal deficit. However, I think the extreme bearishness is a temporary year-end phenomenon where players are wary of initiating fresh positions for the fear of booking losses in March. Markets tend to overreact to both the good news as well as the bad. The rise in yields in the last one month is also an example of this over-reaction. A small positive trigger could change the sentiment and we could see the trading range for yields drop sharply from the present levels.
In the US, bond and equity markets are counter-cyclical but in India, both seem to move in tandem?
Domestic bond markets lack the breadth and depth of the global markets. There is paucity of players in the domestic bond market compared to the equity market and this is compounded by the lack of adequate hedging instruments, which deter new entrants into the market.
    This would be the main cause of bond markets remaining shallow and not fully reflecting the movement of the economic cycles, unlike equity markets.
Does RBI have enough headroom to keep rates soft?
RBI has to balance the twin objectives of stimulating the sagging economy while keeping an eye on inflation. Although inflationary pressures remain dormant at present, the risk of loosening the monetary reins may precipitate demand side inflation, as structural supply constraints contributing to inflation still remain. Although there is still room for further rate cuts, RBI may not be able to emulate the global central banks in aiming for a zero interest rate policy.
Can the market absorb the government's market borrowing programme in 2009-10?
The fiscal situation remains precarious with the government in danger of over-shooting its deficit targets. The budgeted borrowing programme for the coming fiscal is one which the bond markets have never seen before and active management by RBI in its role as a debt manager will be required for a successful completion of the borrowing programme without pressuring yields and crowding out the private sector.
What do you think will be the appropriate response from RBI, given the volatility?
Active intervention by RBI in both the primary market through private placement and in the secondary market through open market operations will ease apprehensions about the over supply of bonds weighing on the market's mind. RBI has to send clear and definitive yield signals and demonstrate its resolve to act determinedly and support its intentions to manage interest rates. I also think understanding the mood of the market, choice of securities, size and timing of the auctions and OMOs will be critical this year.
What is STCI's strategy, considering the volatility and the fact that the market continues to be one-sided?
The road ahead for Primary Dealers is likely to be tough this year. Underwriting government borrowing of such magnitude by this small group will be a challenge. In times of uncertain interest rate scenario, probability of devolvements on PDs remain high and it shall be our endeavour to work with RBI to ensure that borrowings sail through in the least disruptive manner. We would need to adopt a strategy of actively managing the increasing volatility through dynamic balancing of the portfolio and rely on the limited hedging instruments available to insulate against adverse interest rate movements. The introduction of new hedging instruments, including the longawaited interest rate futures would improve the prospects of being able to successfully execute views on bi-directional interest rate movements.
Will a downgrade by rating agencies impact bond markets?
Most certainly a downgrade would impact liquidity conditions in the domestic market as entities will find it increasingly difficult to borrow abroad and FII limits in the bond and gilts may remain utilised to a lesser extent. Further, the impact would be substantial for companies, which would necessarily need to resort to borrowing in the domestic debt markets. The increasing credit needs could lead to waning of appetite for government bonds, rise in credit spreads and an overall upward pressure on both government and corporate bond yields.
    mayur.shetty@timesgroup.com