BANKING: Bond yields spike; Could result in significant MTM hit for few banks in 4QFY07; Valuations largely factors these hits

- Indian bond yields have moved up significantly in 4QFY07, as liquidity declined sharply on account of tax payments by Indian corporates and further auctions of bonds by RBI. Even the call money rate increased to 60% (avg rate of 40-50%) for the last couple of days. We understand that few investors (mainly MFs) have been selling government bonds to cash in on higher yields on short term debt (bulk deposits by banks, call money, etc) - While liquidity is likely to ease from April onwards, decline in inflation from May onwards will also help to moderate yields. Nevertheless, the higher yields in the current quarter are likely to impact 4Q results of banks.

- The 10yr bond yield is up ~50bps over Dec 2006, while the 2yr bond yield (more relevant now as banks have lowered duration significantly) is up ~70bps. At the current levels, most banks are likely to book losses on their AFS portfolio. Few banks like SBI, PNB, Canara Bank, BOB and OBC are likely to witness larger hits as they have higher proportion of their books in AFS category. Other banks like Bank of India, Union Bank, IOB and Syndicate Bank are likely to take very marginal hits due to MTM losses.

- Private banks which have a low-duration investment portfolio and largely hold securities in HTM (Held-to-Maturity) do not carry large risk. Nevertheless, there might be some depreciation on non SLR book, particularly for UTI Bank. - While MTM losses would hurt the bottomline, we believe that core earnings are likely to remain robust. Overall, margins are expected to remain stable (despite rise in deposit costs, as lending rates have also gone up) coupled with stable asset quality. Our discussion with few bankers suggest that recoveries have remained strong in 4QFY07 as well and NPAs could further improve for quite a few banks in 4QFY07. - Overall, valuations are already reflecting the risk on bond books, even as the very near term concerns on inflation and bond losses might continue. We would recommend selective buying. We prefer PNB, BOI, Union Bank and Syndicate Bank among PSU banks. Amongst private banks, we prefer HDFC Bank and ICICI Bank. (Motilal Oswal Securities)