There’s a government bond auction today for Rs. 16,000 cr. for which primary dealers (mostly banks) will be paid underwriting commissions. 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.
In 2013 the underwriting commissions spiked to as high as 84 bps (0.84%) which is a massive amount. But there were HUGE devolvements, with over 1/3rd of bond auctions not getting subscribed. We wrote about this then.
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Two weeks ago, another bond auction devolved. This time the yields had again crossed over to the 8% territory, and the RBI refused to accept the higher bids. About 2,600 cr. of bonds had to be bought by the Primary Dealers. Even then, underwriting auctions had increased to 0.045%, or 4.5 bps. This is about 9x the normal range.
Yesterday, there was an “underwriting auction”. And yesterday, commissions were 5bps for the long term bonds and 1.5 bps for the 10 year bonds, which is nearly 6x to 11x the normal range.
We’ll know the results of the auctions later today, but just as yields remain above 8% (for most of the bonds today) we think there will be some auction failures. The recent rate cut has helped the short-term end of the curve (where yields are now 7.4% for a 1 year bond)
Our View: Bond yields rising are a huge problem and they are doing so worldwide. The spreads between near and long term bonds have gone really wide now. A change of this sort is terrible for the banking system that holds bonds, is not great for long duration mutual funds, and also hurts insurers who have to put certain amounts of money in government bonds. It also hurts the government’s finances in that they pay more than expected for borrowing.
Overall, a rising bond yield market is a negative, as it equates to rising long term rates while short term rates are falling. It’s a negative for the economy, but in the longer term, it’s likely to be a better “normal” because that’s how things are supposed to be – you pay more for borrowing for a longer term than for a short term.
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