FRAs back in vogue, help insurers in fixed rate of interest for payouts

Photo of author
Written By WindowsHindi

Lorem ipsum dolor sit amet consectetur pulvinar ligula augue quis venenatis. 

With the Reserve Bank of India (RBI) announcing two rate hikes since May, the June quarter was challenging for banks when it came to managing their bond investments.

While government bond yields hardened across maturities, securities maturing in 30 years and above witnessed a much smaller yield increase. Bond prices fall when yields rise and vice versa.

In 2022, so far, the yields on five-year and 10-year government have surged 131 basis points and 93 basis points, respectively. The yields on 30-year and 40-year bonds, on the other hand, have climbed 62 and 58 basis points, respectively, during the same period.

The slower pace of rise in longer-term bond yields has contributed significantly to the flattening of the sovereign yield curve. This implies a relatively low cost of funds for entities whose long-term borrowings are benchmarked to government securities.

According to treasury officials, a key factor that facilitated firm demand for longer-term — and hence capped the rise in their yields — was increased use of derivative transactions between insurance companies and certain banks.

The transactions in question, Forward Rate Agreements (FRAs), essentially enabled insurers to lock in a fixed rate of interest rate for a future pay-out, thus helping guarantee specified returns to customers. were said to be buying long-term on behalf of insurance companies.

Under the current norms, the permits FRAs but does not permit bond forwards in the Indian government securities market. A bond forward trade would entail the transfer of a security from the books of one entity in the trade to another.

In an FRA, the two counterparties to the trade agree to receive or pay the difference that stands between an agreed rate and the rate of interest prevailing on a date in the future. The transaction is based on a notional amount, with the underlying being government security.

The growing use of the trade stems from the fact that bond yields have seen large swings over the past year due to huge debt supply, rising inflation, and the commencement of the RBI’s rate hike cycle. Treasury officials told Business Standard that trades worth more than Rs 2 trillion were linked to FRAs. These trades were said to have started a couple of years ago.

were said to be utilising such a trade as a means to bet on the rising interest rate environment and earn a sizeable ‘carry’ or spread over the relevant cost of funds — in this case, the one-year overnight indexed swap rate.

“Insurers need a mechanism by which they can lock in today’s rate of 7.5 per cent or 6.5 per cent or whatever the rate is on their product. If they want to lock in the rate, they enter into an FRA with a foreign bank. Thereby after one year, they lock in a bond yield which prevails now,” said a senior treasury executive at a foreign bank.

“Where banks have an advantage is that banks are leveraged players. They can buy the bond and the funding rate will be a bit above the call money market or a bit above the OIS (overnight indexed swap) market. Then the bank says that since the average funding rate for the next year will be 6.10 per cent, it will charge the insurance company 60 or 70 basis points above that. So, the bank earns that carry of 60-70 bps,” the executive said.

The increasing use of the trade comes at a time when other tools to hedge against the rising rates, such as floating rate bonds, have witnessed hefty price declines in the secondary market due to heavy supply, traders said.

have been increasingly opting for the use of the FRA product over the past couple of months due to heavy losses incurred in the highly liquid 2034 floating rate bond issued by the government, dealers said. The floating rate bond, which is typically a hedge against rising interest rates, has seen its price fall by more than Rs 3 over the past five months because of a glut of supply of the paper.

“A bank doing an FRA today, going through this complicated mechanism, will probably make 40 or 50 basis points higher by just buying the floating rate bond,” the foreign bank executive said. “But the problem with the floating rate bond is that it gets marked-to-market. And people are not willing to face marked-to-market losses.”

In April, media reports stated that FRA trades were under the RBI’s scanner and that the central bank had asked some foreign banks to pause such transactions.

The reports said that the rules did not specifically clarify the benchmarking of FRA trades to securities, such as OIS rates, and that the transaction may have been in a regulatory grey zone.

Among the banks mentioned in the report were HSBC, Bank of America, Barclays, Citigroup, and Standard Chartered.

Source link

Leave a Comment