Hedging interest rate risk becomes easier:: Business Line

The modified interest rate futures set for launch by the National Stock Exchange and the MCX-SX will provide Indian investors an effective means to hedge the fixed income portion of their portfolio. It will also be useful for cutting down the losses incurred by way of higher interest outgo on loans or lesser interest income on fixed income assets due to fluctuations in policy rates.

The need for protection against volatility in rates was never higher than in 2013. The holders of government bonds would have seen the value of their bond portfolios fluctuate in a manic manner in this period. Banks that hold 34 per cent of government bonds got a reprieve from the Reserve Bank of India as it allowed them to reset the bond prices to bring down their losses. But other holders such as provident funds that hold 18 per cent of outstanding G-Secs, insurance companies that hold 19 per cent or mutual funds that hold 1.2 per cent and FIIs who hold 1.6 per cent would have seen a dent in their fixed income portfolios.

The new interest rate future offers such investors a viable option to protect themselves.

What has changed?

This is not the first time interest rate futures are introduced in the country. Indian exchanges currently do offer IRF contracts — one on a 10-year government security and another on a 91-day treasury bill.

But there is hardly any trading in these. One reason for this state of affairs is that the underlying instrument for these IRFs was a notional 10-year bond with a fixed 7 per cent coupon rate. Investors then had no way of hedging against holdings of real 10-year bonds floated on different dates with varying coupons. Secondly, the contracts were physically settled.

Since the seller had the option of choosing from a basket of 10-year securities to make the delivery, the buyer would often find himself at a disadvantage.

The concerns of the market have now been addressed and exchanges have been allowed to issue cash settled IRFs with a single traded government bond as underlying, thus doing away with the earlier confusion over settlement. Cash settled instruments are also likely to attract greater trading interest and hence improve liquidity.

The National Stock Exchange has released the details of the modified IRFs, now called “NSE Bond Futures.” These futures will be issued with tradable government bonds with 7.16 per cent and 8.83 per cent coupon rates as underlying.

Since the 8.83 per cent bond is closer to the current yield of 10-year G-Sec, it is likely to be more popular among hedgers. These bond futures are also going to be settled in cash.

Who can use them?

It is obvious that holders of government bonds will be the direct beneficiaries. The RBI has allowed banks to trade in IRFs on their proprietary books but not on behalf of their clients.

This is a great relief as commercial banks hold the largest chunk of government bonds and are likely to be the biggest users. Again, since these are complicated instruments, banks would be best placed to understand them and trade them. Movement of prices in the IRF can signal the expectations of the market to RBI, helping it in its monetary policy decisions.

But it is not just banks and other institutions, even retail investors can use IRFs for hedging interest rate risk. If you expect interest rates to move higher, it will mean that interest outgo on your loans will move higher too as many investors have locked in to floating-rate loans.

You can neutralise this additional outgo by selling NSE bond futures. Since bond prices and yields move in opposite directions, your position will yield a profit due to falling bond prices.

Similarly, if the expectation is that interest rates are to move lower, interest income on your fixed income portfolio will dip. You can compensate this reduction by buying IRF.

Apart from these, traders can now use IRFs for pure directional calls on interest rates too. For instance, if you think the RBI is going to reduce repo rate in the monetary policy meeting next week, you can go long in the interest rate futures and vice-versa if you think the rates can be increased.

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