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10 year PIB cut off yield came down marginally in the latest auction. No change in the rates of 3 & 5 year papers.  Government fetched the amount as per the target –Rs100 billion in fixed rates and Rs 50 billion in floating bond. The yield came down in 10Y as there is appetite by the insurance companies and pensions funds. Banks are missing the bus.

Government fetched Rs20 billion in 10Y fixed PIB at 10.9 percent – down by 9 bps from last auction. The buzz is that all the amount is taken by insurance companies and pension funds. The next bid was at 25 bps higher (probably by a bank or more). DG debt at MoF is in no mood to increase the yield and is happy to fill in the appetite of non-banks. Had it been on the discretion of banks, the rates could not have come below 13 percent.

Due to recent maturity of PIBs, insurance companies and pension funds are hungry for long term bonds. They usually have long term liabilities, and to match they ought to have long term assets in their respective portfolios. Banks on the other hand borrow at (or around) policy rate (or it is deemed to be the opportunity cost), and its hard from them to carry negative spread on long term bonds. Plus, they have to mark to market the bonds.

 

The banks are carrying negative spread on long term assets borrowed on higher short term rates. The bet is that in the medium term interest rates will come down. For that inflation has to be low in the medium term. SBP is targeting medium term inflation at 5-7 percent. With upcoming amendment (at draft stage), SBP will singularly (or aggressively) target the medium term inflation. Once the credibility of SBP inflation targeting is entrenched, banks will start investing in PIBs at prevailing rates (or even at further discount).

The math is simple. At this point banks are carrying negative spread of 2-2.5 percent on short term borrowing for investing in 10 Y PIB. If the medium term inflation to come down to 5-7 percent – let’s assume at 6 percent - the policy rate could be around at 8 percent in couple of years. At that time, investment in 10Y bond at 11 percent will be at premium of 2-3 percent.

For the assumption of inflation to come down, the actual decline has to be seen in the second half of this calendar year. Right now market is confused on the inflation outlook. The inflation is expected to come down; but revision in energy prices, threat of oil prices moving south, new taxation measures and second round impact of recent food prices hike could result in inflationary pressures.

The inflation trajectory has to come down for banks to believe that medium inflation target could be met. But there is an opportunity cost in this wait. Banks are not used to competition in bond market. The appetite of pension funds and insurance companies is high. The other element is of foreign portfolio investment (hot money) coming in long term.

After resolution of taxation issues, now foreign portfolio managers are inquiring about long term bonds. They might not have invested much in the latest auction. Time is not far before they start investing. The banks would have more competition. Once the yield start coming down in 3 & 5 Y (or further in 10Y), banks would jump invariably.