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Bond Markets Crash, Failure of Bond Auction Today is Likely Again

There’s some serious damage in the bond market in the last few days. We posted (in Premium) that Banks are likely to lose 10,000 cr. on just the extra exposure they have to government bonds. And look at how much bond yields have risen:


(Rising Bond Yields = Falling Bond Prices = Losses on your bond portfolios)

From the orange line (1 month back) you see how, after the Jun 02 rate cut, markets have taken longer term yield up significantly, while short term yields have fallen.

This Affects Mutual Funds, but only the Long Term Ones

Mutual Funds that hold long term bonds will be affected. Some bond funds like liquid and ultra short term funds will actually be giving awesome returns. See the short end of the yield curve – at this end there are gains, not losses, for bond holders. (But gains are muted because these are short term bonds).

Long duration mutual funds – typically the Gilt funds, most of the dynamic funds and so on – will have lost money. Many will have lost around 2% in the last month. You might make back some of that loss due to the interest component (a yield of 8% means 0.67% per month comes back as interest), but even counting that, there’s a loss in holding such funds.

Our view: While we won’t invest any more right now, considering this bond market move, it isn’t yet time to sell everything.


There’s Likely To Be A Bond Auction Failure Today

RBI will auction Rs. 15,000 cr. of bonds today. Last week we noted that underwriting auctions were very high (5bps, 6 to 11x normal) and guessed there would be an auction failure. And there was, the second auction failure in a month.

What are underwriting auctions? Here’s a gist from that post:

These commissions are “bid” for; that is, banks bid for how much they will underwrite (they have to underwrite at least half the auction, they bid for the rest), and how much they want to be paid.

If the auction succeeds they will be paid the commission anyhow. If the auction is not fully subscribed, then whatever part is undersubscribed is “devolved” upon the underwriting primary dealers. Meaning, they have to buy the bonds if no one else does.

Typically this is easy money since everyone wants government bonds. So commissions are of the order of 0.005% or less. That is 500 rupees per crore, so even a 16,000 cr. auction will probably net the whole primary dealer system only about Rs. 50 lakh. This is not much by banking standards, but it’s there to keep incentives in place.

What happens when dealers think they can’t sell the underlying bonds in the auction? They will then fear that they have to buy the devolved bonds, which they have to then dump on to the marketplace. In that process they will lose money (anyone dumping anything desperately will get a lower price). To compensate, at such times, banks demand larger underwriting commissions.

Yesterday, the commissions demanded by banks went EVEN HIGHER: to as much as 8 bps. (link)


A typical auction is around 0.1 bps to 0.4 bps. We are now seeing 10x to 20x these numbers as commissions, meaning underwriters expect these auctions to fail and therefore they could lose money on having to buy and hold them.

The bond market issues will weigh on equities, specifically banks in trade in the next few days.

  • Gaurav says:

    Hi Deepak,
    Question – if this continues, then is there a possibility that the RBI gets involved? If it does, then what form would that take. Could the RBI undertake a QE program? That would certainly push down rates at the long end. The rate cuts by the RBI certainly don’t seem to be doing much are they? Or does the RBI simply put its hands up? I can’t imagine recapitalizing the PSU banks will really help – if anything it will just kick the can down the road.
    Or, on the flip side, will the government step in and enact some other fiscal policy boost (I’m not sure because they’ve just managed to trim down the deficit)?

  • Gold Bug says:

    Data from EPFR show that Equity Funds in Asia, Latin Am and Emerging world bled 9.27 B $ in week upto June 10 surpassing exodus last seen in mid 2013 “taper tantrum”. Small investors have been pulling funds out of EMs for several months but big pension funds and Institutions have until now held firm. There is a danger that these biggies could exit at the same time for narrow exit exhibiting a herding behaviour.
    In bond markets the real rates in EMs have now become just one percent and there is a strong incentive for them to pull out the money for expected higher rates in US.
    Unfortunately I find most Indian Bond Fund Managers are bullish on duration Bonds. This is the time for them to switch to short term T bills at least in Dynamic Bond Funds to protect their investors. But they will never learn.