Will debt market come to life after TT waiver?

Sell bonds, wear diamonds

TARINI VAIDYA
Country Treasurer,
Centurion Bank

While market participants had expected (and prayed for) some reduction in the turnover tax on debt market transactions, none had even dared hope for a complete removal.

However, the initial euphoria over the surprise removal of the tax was woefully short-lived. The fact that the rally was so fleeting is indicative of a deeper malaise inflicting the markets.

The good news on the tax front coincided with, and was indeed overshadowed by, hawkish comments from the US Federal Reserve chairman Alan Greenspan, indicating a further tightening of US interest rates in the months to come.

To analyse what's happening in the Indian government bond market, it's pertinent to dwell on the recent past. On March 31 this year US 10-year Treasuries were quoting at a yield of 3.84 per cent and the Indian 10 year government bond was at a yield of 5.16 per cent. By the middle of April the US-10 year yield had jumped to 4.40 per cent but the yield on Indian 10-year bond actually fell to 5.08 per cent.

This was largely on account of ample liquidity (with almost Rs 75,000 crore being given to the RBI under its liquidity adjustment facility) and an apparent disconnect between our economy and that of the rest of the world.

The US 10-year Treasury yield is back at those levels (4.45 per cent) while the benchmark Indian 10 year government bond is at 5.92 per cent. So what's changed?

The intervening period has been eventful. We've had a change of guard at the government, a budget and financial arbitrage opportunities for non-resident Indians have been removed.

In addition, we've had surging inflation and rising international oil prices. Even the most ardent bond bull would have had to retreat, injured and defeated, in the face of such an onslaught of negative news. What comes next?

Not much by way of positive factors. US rates will inch up. Domestic inflation is already at 6.5 per cent where it may stabilise over the course of the next few months.

However, international oil prices remain skittish. If there is continued tension in the Middle East and oil prices rise further, domestic inflation could tick up.

An additional worry is the monsoon. If we have a below par monsoon, prices of agricultural commodities will rise. The specter of a drought in some states only exacerbates the problem.

The government's finances are a concern. While the increased budget allocations for the poor are unarguably commendable, they do put pressure on the exchequer. Will tax collections be robust enough to meet budget estimates? There is some skepticism here.

Will the Indian equity market find flavour with overseas investors once again? For the moment they are likely to adopt a wait and watch stance and may stay on the sidelines until the beginning of the next calendar year. A decline in foreign exchange inflows, together with the RBI's bond issuance programme will dent the liquidity overhang in the system.

The bond market is nervous, and the slightest bit of negative news results in a wave of selling. Sell bonds and wear diamonds? Definitely. Bond prices are headed lower over the course of the ensuing months.

However, the move is unlikely to be unidirectional and the market will provide some opportunities to make money. Be nimble and (if you are not faint hearted) you could still make money buying bonds and picking the right entry and exit points.

Thank you, Finance Minister

M S ANNIGERI
Chief executive officer,
Fimmda

The securities transaction tax (STT) issue has been resolved and all the affected parties are heaving a sigh of relief. The major players in the debt market have all along been treating income from securities, whether by way of interest or by way of trading gains, as "business income", and paying tax accordingly, at appropriate rates.

For the debt market players, the reduction in "long term" or "short term" capital gains tax was of no consequence, as their tax liability arising out of income from debt securities remained unchanged.

The dynamics of the debt market were quite different from those of the equity markets. Normally, investments in the equity markets are made with the primary objective of earning capital gains; dividend income is incidental.

However, in the debt markets, the primary objective of investment is interest income; trading profits are incidental.

An appreciation of 4-5 per cent in a short of period of 1-2 days is not unusual in the equity markets, whereas an identical appreciation in G-Sec prices would create waves.

Therefore, an investor in the equity market would not mind paying a transaction tax of 0.15 per cent but the same rate for debt market trades would be out of sync with the profit margins in this segment.

It would perhaps be interesting to analyse the importance of a deep and liquid G-Sec market, in the context of a number of observations that the imposition of a transaction tax would adversely affect the liquidity in the G-Sec market.

Over the last few years, RBI has initiated a number of measures, which has helped build a robust secondary market in G-Secs.

The active market in G-Secs has helped banks to classify a good portion of their SLR portfolio as liquid assets, which in turn has helped banks in their asset liability management.

Further, banks have been able to raise or reduce the interest rate risk of their portfolio by actively managing the duration of their G-Sec holdings.

The active participation of a large number of banks, primary dealers and financial institutions in the G-Sec market has helped develop a robust sovereign yield curve, which has served as a benchmark curve for all the interest rates in the financial system.

The "spread over G-Secs" nomenclature has acquired a high degree of acceptance in corporate financial circles. Needless to add that the active secondary market has also helped bring down the yields on G-Secs and as a result, the cost of borrowing for the government.

With a well developed G-Sec market, the stage is now set for development of a robust corporate bond market, coupled with an active interest rate futures market.

Given the fact that investment in corporate bonds would call for higher capital, it is imperative that the risk management systems in banks and financial institutions be toned up to ensure a better risk adjusted return on capital. Trading in bonds across the rating and maturity spectrum will provide the necessary momentum for development of this market.

A vibrant interest rate futures market will provide the market with a tool for risk management and promote interest amongst both issuers and investors, thus helping develop a complete bond market.

We could all look forward to a variety of products in the bond markets to cater to the risk appetite of different investors. The government has cleared the path for the development of an active bond market and we must thank the finance minister.