RISK-REWARD GREAT FOR DURATION EXPOSURE THROUGH HIGH QUALITY CORPORATE PAPER

I have been part wrong and part right as far Indian fixed income markets are concerned. 

DURATION EXPOSURE DID NOT PAY OFF IN Q1 2009; THE SHORT-END LOOKS ATTRACTIVE

I underestimated the brute force of supply pushing government security yields higher. Overnight indexed swap rates climbed as market-players probably paid to hedge duration. Yields rose on corporate paper as well.

Yet, the current yield levels – particularly the short-end - seem totally out of line with the cyclical reality, even after accounting for significant fiscal stimulus led issuance. Persistent excess liquidity is likely to be the norm going forward. I am also confident that the Reserve Bank is unlikely to lift the reverse repo rate over the next year. Given this backdrop, the short-end seems very attractively priced.

Consider the following investment-buy 1-year Government securities financed in repo with a haircut of 10%. Based on the current 1-year spot rate (5.35%) and daily call funding at 3.5% over the next 1-year, the return on equity on this investment will be 22%.

On the OIS front, the 1-year spot rate 1-year forward is 4.78% currently. This implies almost a 100bp increase in the 1-year spot OIS over the next 12-months – a scenario that seems extremely unlikely to me. A clear trade here is to receive the 2-year OIS versus the 1-year (receiving the 1-year OIS, 1-year forward).

SPREAD DURATION EXPOSURE TO HIGH QUALITY CORPOARTE PAPER REWARDED HANDSOMELY; ABSOLUTE YIELD LEVELS VERY ATTRACTIVE

The yield on the FIMMDA Bloomberg 10-year AAA corporate bond index rose about 55bp point in the first quarter of 2009, but the spread over 10-year Government security yield declined to 172bp on April 3, 2009 from 284bp on December 31, 2008. This spread averaged 111bp since December 2001, with a standard deviation of 76bp. At this point, the risk-reward for spread duration exposure does not look that great, but absolute yield levels on a diversified basket of corporate paper look attractive. Clearly, this is the time to assume duration exposure through high quality corporate paper.

RBI ANNOUNCES PLAN TO BUY INR 800BN GOVERNMENT SECURITIES

The overall structure of interest rates cannot decline unless base risk free yields fall. And, RBI’s latest move indicates that the central bank is alive to this issue. From the perch of current yield levels, long duration exposure makes sense. The ultimate aim of policy-makers is to reduce borrowing costs for the industry and that is where long positions would be most rewarding.