Mumbai: Bond forwards in sovereign debt, for which the Reserve Bank of India released draft directions last week, will help end a regulatory grey area and let banks and insurers cater to the trillions of rupees worth of retail demand for long-term investment products in a standardised manner.
Introduction of bond forwards, which are derivative contracts between two counterparties to buy and sell a specific security on a future date at a predetermined price, will also bring more depth in the country’s bond pricing benchmarks in line with advanced economies.
The RBI said on December 28 that bond forwards would particularly help long-term investors manage cash flows and tackle interest rate risk, and invited feedback on the draft directions by January 25. No timeline has been given for the launch of the product.
INSURANCE-BANK CONNECTION
The RBI’s move to introduce bond forwards comes after three years of exceptionally strong demand for long-term government securities from insurance companies.
Trades between insurers – looking to lock in a long-term return – and foreign banks are being largely carried out in the form of a complex derivative called ‘forward rate agreement’ (FRA). This is not dissimilar to a bond forward, but there are no clear guidelines to regulate the product.
“It (the RBI move) is a very welcome development because it gets the product recognised and it would bring in uniformity in terms of the way the market treats the product on its books. Second, it is a bond forward now, not a bond FRA which was prevalent in the market. To that extent, it now allows for delivery as well as clearing – previously a grey area,” said Nitin Agarwal, head of trading at ANZ.
Insurers need long-term government bonds, which are risk-free instruments, to hedge their long-term liabilities. What the bond-FRA did, and bond forwards would do going ahead, was providing insurers with a fixed return from a government bond which could be bought by the insurance company at a later date. Foreign banks, meanwhile, were using their own funds to buy bonds on behalf of insurance companies and then hedging that exposure in the market.
With the RBI bringing in bond forwards, banks and insurance companies would have greater confidence to offer the product, and the treatment of it in accounting and balance sheet would become standardised.Market insiders said the prevailing practice of carrying out bond-FRAs meant banks taking different approaches for the treatment of the bonds, as mandated holdings of high-quality liquid assets or assets eligible for computation of the liquidity coverage ratio. Such differences were sometimes pointed out by the RBI in its audits of banks. “The foreign bank exposure was fully hedged, and the attractiveness of this product stemmed from the fact that government bonds can be used in repo transactions for funding. If there was a funding risk, then foreign banks would not be able to offer this product and then the retail public, which was getting a guaranteed return of 6.5% or 7% – that would not have been possible,” a person in the know said.
