February 11, 2009

More bond supply to chew

Governments all across the world, including US and India, are all out to do everything they can (and more) to save growth. Between US and India, the difference just being that the US Fed Reserve Chairman and their Finance Secretary has to officially justify and testify what they are upto. Back home in India, we get to know about what has already been done. No questions asked. More like, no one to ask.

If we are unhappy about what is being done, we sell stocks and bonds. Quite simple. And so bonds have been bearing the brunt of these growth-saving-efforts. Government wants market to fund it another Rs.46,000crores over the next 6-8 weeks. Phew.. So much to absorb, literally. With this, the total amount of auctions has reached Rs.231,000crs (gross) for the current fiscal. Out of these, banks alone have bought Rs.164,000crs. Add the demand from insurance companies, primary dealers and mutual funds, fact is the supply might be short of the requirement!

Last few weeks, the yields have been surging, prices dropping. Does it hit my stop-loss as a bond buyer? Not really. I would look to add more. Underlying bullish trend still remains firm, the rally just being postponed for the time being.

Let's see why. Excessive supply of bonds is negative for the market in two ways. Firstly, the liquidity angle. Supply of bonds equals absorption of system liquidity. But only temporarily. Government is borrowing BECAUSE it wants to spend. So money has to flow back sooner rather than later. Also, if there is even a short term liquidity mismatch, RBI will step in swiftly to infuse money by buying more MSS bonds or cutting CRR or if need be, both.

Coming to the second impact, that of higher supply of bonds due to auctions. That is, demand being equal higher supply can be absorbed only by reducing prices. If you look beyond the obvious, the long and short of it is that MSS bonds are being replaced by Non-MSS bonds in the investors' portfolio. There is no NET increase in the stock of bonds available really. That is why buyers won't really feel the weight of auctions in these times.

To put numbers into this statement, the total amount of MSS bonds bought back during Oct. 2008 till date is Rs.65,040 crs. Total auctions during the same period was Rs.86,230 crores. Redemptions during the period was Rs.11,450crs. The net increase in outstanding bonds in the market, hence, is only Rs.9,740crs. During the same period, the net accretion to banking system's deposits was Rs.187,940crs. Incremental SLR demand on this comes to Rs.45,105crs. Now, compare 45,105 with 9,740 and you will know why the yields are so lower than what they were in October 2008. The demand side from other generic buyers apart from banks have not been considered in my calculations. (For basic readers of this blog, hope the math is not very confusing)

Point is, me thinks this situation will continue. Meaning, the pain of incremental supply is not really a lot. Look at the armory with the RBI. CRR is at 5%, can be cut to 3% without any hitch. That's about Rs.72,000crs of liquidity. Outstanding MSS is Rs.108,764crs. Add both, and there's a lot of money to be released if need be. Don't forget, we are already sitting on a surplus liquidity of Rs.43,000crs approx.

Now, if interest rates still have to come down by 150-200bps over the next few months (my views expressed in earlier posts still hold good), yields can only go one way - DOWN. And so, I'll look to buy more gilts through my favorite ICICI Pru Gilt Fund.

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