July 21, 2011 3:51:25 PM
KENYA-BONDS/ (ANALYSIS)
* Higher yields driven by inflation expectations
* Liquidity squeeze in money markets raises risk
* Equities could benefit from stalemate
By Duncan Miriri
NAIROBI, July 21 (Reuters) - Investors in Kenyan bonds will continue seeking high returns from the government, defying the central bank's efforts to rein in rates by rejecting expensive bids at auction.
The central bank has rejected billions of shillings in recent sales of government securities to contain a jump in yields that has distorted the curve and brought losses to investors' portfolios.
The jump in yields was driven by inflation expectations after the year-on-year rate galloped into double digits in the six months to April, rising further to 14.5 percent in June.
During this week's auction of two- and 10-year bonds for 13 billion Kenyan shillings ($144 mln), the central bank took only 6.79 billion shillings of the 15.32 billion offered by investors, underscoring its determination to rein in rates.
A tightening cycle to fight inflation and stabilise the exchange rate could however delay the aim of lowering yields as investors price in funding risks, market participants.
"For as long as we continue to see uncertainty on the short end of the curve, people will go to the auction but bid higher to cover themselves for any funding risks," said Duncan Kimani, head of trading at Commercial Bank of Africa.
The central bank placed tough new rules for banks borrowing through its overnight discount window last week, causing a liquidity crunch and sending the average overnight rate on the interbank market to a high of 10.675 percent earlier this week.
The rate has since fallen to just over 8 percent after the central bank pumped in money through reverse repurchase agreements on Monday and Wednesday to stave off a crisis in money markets when firms start paying taxes this week.
James Chweya, a fixed-income trader at Standard Chartered Kenya said the central bank may have to reject bids even more aggressively to allow the market to correct the unprecedented anomalies in the yield curve.
For instance, the difference in the yield between the two-year Treasury bond and the 10-year Treasury bond stands at just 40 basis points.
During Wednesday's sale, the yield on the 10-year bond rose to 13.089 percent from 12.531 percent at its last sale in May, while that on the two-year bond inched up to 12.684 percent from 12.442 percent at the last sale in June.
"If they feel it is too painful to pay here, they should stay out and postpone their borrowing, then the market will correct," Chweya said.
"For as long as they stay in the primary market, then we are not going to see a quick correction."
STALEMATE
Ignatius Chicha, treasurer at Citi Kenya, said a stalemate would likely develop with investors building up cash positions as a result of central bank's rejection of bids.
"There will be a stalemate until someone gives," Chicha said.
"People could go into equities and if nothing much happens, people could start sitting in foreign currencies."
Just one month into the fiscal year, some market traders said the central bank might look to back-load its borrowing in expectation of yields falling.
"They can decide not to pick high yields and lower the volumes. If they could have done that last year, the rates would not have gone up," said George Nyaga, a fixed-income trader at Ecobank Kenya.
During the first six months of the year when yields were rising, traders partly blamed the central bank's acceptance of bids at any rate for driving prices up and causing losses to existing portfolios when they were marked to market.
Traders said calm would only return to the market once the bank convinced the market that its inflation forecast of 7.5 percent by the end of the year -- more benign than the market's -- is realistic.
They also want to see how the bank will manage liquidity in the market after it raised its overnight rate to banks to 8 percent from 6.25 percent only to cut it back after a week.
"Liquidity pricing is still high. The signals are very erratic and in an erratic situation which is clearly volatile, you cannot pretend to be a calm player in the market," Chweya said. ($1 = 90.050 Kenyan Shillings) (Editing by Richard Lough, Ron Askew)
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