The Hindu Business Line : Softening bias for interest rates

THE bond market had a stable month with a firm undertone during July. The market, initially, was apprehensive of the new Finance Minister resorting to populist steps and rolling back some of the interest rate reduction measures taken by his predecessor.

Though the Finance Minister announced some changes in personal taxes, he left the interest rate regime untouched. He re-iterated the softening bias for interest rates and did not make any changes in the interest rates on small-savings instruments. Government securities supply through auctions and open market operations (OMOs) kept the market on its toes.

Liquidity in the system has been comfortable through the month and this helped the market absorb the supplies. The scheduled auction at the beginning of the month sailed through, with a minor devolvement on primary dealers on the 15-year security. The paper carried a floating rate coupon with a spread over the 364-Day T-Bill cut-off yields. The RBI also announced an unscheduled auction in the middle of the month. For the first time, the Government of India securities were issued with put and call options. The 10-year paper carried a put and a call option at the end of five years and every six months after that. Thus, the 10-year paper becomes a five-year paper. There was a devolvement in this auction too, but it was read more as a signal from the RBI, ostensibly seeking to prevent a rise in yields.

Yields softened through the remainder of the month, despite a couple of OMO sales, which absorbed some of the excess liquidity in the system. A clutch of nationalised banks, led by State Bank of India, reduced the interest rates on their deposits by 25 to 50 basis points. The consequent reduction in the cost of funds for these banks made the lower yields on their assets more sustainable.

Moreover, the Finance Minister announced a new tax-free bond offering a lower interest rate than that available on the current the RBI Relief Bonds. These reductions in interest rates spurred sentiments in the bond market and by the end of the month, yields were close to the lows set earlier during the year.

The corporate bond market followed the yield movements of the Government securities. The low yields attracted a number of issuers looking to borrow for longer tenures.

The easy liquidity in the system enabled the market to absorb these issues. The low yield levels also led to demand for the higher yielding sub-prime rated securities. As a result, yield spreads between the best grade credits and the lower rated credits narrowed and these sub-prime credit grade papers were the best-performing corporate bonds during the month.

Interest rate movements are expected to continue to be stable with a softening bias. The weaker than forecast monsoon over large tracts of the country has led to a reduction in the expected growth in the agricultural sector for this year.

Some analysts have already cut the GDP growth estimates. The Government's expenditure, in the current year, is expected to exceed the budgeted amount on account of `drought relief'.

Revenue growth is also expected to be affected by the economic slowdown. However, interest rates are expected to stay soft so as to give a boost to industrial growth and compensate for the agricultural slowdown. Major economies around the world are seeing slower than anticipated growth. The monetary authorities are expected to adopt a softening bias to interest rates. A softer interest rate environment around the world will help the RBI in maintaining its soft interest rate bias.

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