Bonds carry huge price risk

B. Venkatesh

BONDS have been making merry in the last fortnight, and not without reason.

The 200 bps cut in the CRR and the 50 bps cut in the bank rate by the Reserve Bank of India (RBI) in its latest Credit Policy were good enough reason for dealers to bid up bond prices. But will the rally sustain in the coming fortnight? That seems unlikely, for the following reasons.

First, the price risk in the bond market is high. The 10-year bonds now trade at yields of 8.8 per cent. At current yields, the term spread between the one-year and the 10-year bonds is just 200 bps, well below past averages.

A mean-reversion in spreads could see either a drop in short-term yields or increase in the long-term yields. A drop in short-term yields appears unlikely at this point in time because the one-year bond yields are hardly 30 bps over the current bank rate.

This means that yields at the long-end will have to fall to bring spreads to normal levels. The price-risk is higher at the long-end, where the yields from 10-to-20 years have been compressed between 80 bps. This seems a function of demand, as dealers are buying long-term bonds to increase the yield points in their trading book.

Second, the liquidity in the market is tight. A reflection of this is the fact that, as on November 1, 2001, banks have borrowed from the RBI to the tune of Rs 7,800 crore, besides Rs 9,525 crore under reverse repos. The tight liquidity condition is despite the RBI cutting CRR by 200 bps.

The reason is that SBI's India Millenium Deposit and Resurgenent India Bonds are likely to attract CRR, unlike earlier when these deposits were exempt from such computation. This has taken SBI out of the call market where it is a major lender. The upshot is that call rates are likely to remain firm for sometime. A higher call rate may impinge on the bond prices and shift the yield curve upwards.

Third, the Government is running close to its WMA limits. This may prompt the RBI to schedule a bond auction soon to raise money for the government. And that may dampen the dealers' enthusiasm to bid up bond prices now. In all, bonds appear to run a huge price risk, and carry a downside from the current levels.