KARACHI, April 28: The maximum yield on 10-year bonds rose to 6.49 per cent in an auction held on Wednesday from 6.23 per cent in December last year. If the trend lasts through the next auction in May then there will be a lesser-than-anticipated reduction in the rate of return on 10-year Defence Saving Certificates or DSCs.

The State Bank sold Rs15 billion 10-year Pakistan Investment Bonds or PIBs at a cut-off yield of 6.49 per cent up 26 basis points from the previous level of 6.23 per cent. This was part of the total sale of Rs26.3 billion worth of PIBs of different tenures against the target of Rs25 billion. But the market demand was pretty high at Rs47.1 billion.

The auction result announced by the central bank showed that the weighted average yield of 10-year PIBs also went up by 24bps - from 6.21 per cent to 6.45 per cent. The central bank plans to auction another lot of Rs10 billion PIBs next month.

Senior bankers say the cut-off yield on the bonds may rise further in the next auction. If that happens then the government will have to make a lesser-then-anticipated cut in the rate of return on 10-year DSCs.

The next six-monthly review of the rates of return on National Saving Schemes or NSS including DSCs is due in July. Under one of the conditions attached with the $1.5 billion IMF-sponsored Poverty Reduction and Growth Facility the government is supposed to align NSS rates with the yields on PIBs of similar maturities.

This alignment is to take place in July when the government is due to announce revised rates of return on NSS. The government and the IMF have already worked out a formula for this purpose.

The current rate of return on 10-year DSCs is 7.96 per cent - far higher than the weighted average yield on 10-year PIBs that is at 6.45 per cent. So at present the spread between the rates of return on 10-year DSCs and PIBs is 1.51 per cent.

Before the 24bps increase in the average yield on 10-year PIBs on Wednesday the spread was 1.75 per cent. If the PIB yield rises further in May - the chances for which are bright - then the spread between the rate of return on 10-year DSCs and PIBs would shrink further.

As a result the government will have to make a cut in the rate of return on DSCs much lesser than what otherwise required i.e. in absence of improvement in PIB yields.

Senior bankers anticipate that the yield on 10-year PIBs may rise by another 20bps in May. If that happens then the spread between the rate of return on 10-year DSCs and PIBs would fall to roughly 1.30 percentage points.

But the government will not have to make even this much cut in the return on DSCs because the formula set for alignment of the rates of return on NSS-PIBs does provide some cushions.

Sources close to the ministry of finance say the government may have to reduce the return on 10- year DSCs by not more than 60-80bps in July i.e. if the 10-year PIB yield rises by another 20bps in the next auction in late May.

But if the yield remains unchanged then the return on DSCs may decline by 80-100 basis points. This means the return on DSCs may fall to around 7.30-7.00 per cent in July depending upon the level of change in the yield on 10-year PIBs in the next auction.

But the likely reduction in the rates of return on five-year Regular Income Certificates and three-year Special Saving Certificates may be much sharper. The reason is the gap between the returns on these certificates and the yields on five-year and three-year PIBs is very wide.

On Wednesday the cut-off yield on five-year and three-year PIBs declined by 11bps and 18bps respectively to 4.90 and 3.77 per cent from 5.01 and 3.95 per cent. The central bank managed to sell about Rs8.35 billion five- year PIBs and Rs2.95 billion three-year PIBs at these cut-offs.

The weighted average yields were also down modestly to around 4.87 and 3.73 per cent from 4.98 and 3.93 per cent in the last auction held in December 2003.