Fashionable return FRAs help insurers charge a fixed interest rate for payments

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

While government bond yields tightened across all maturities, securities maturing in 30+ years saw a much smaller yield increase. Bond prices fall when yields rise and vice versa.

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

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

According to Treasury officials, a key factor that facilitated firm demand for longer-term bonds – and therefore capped the rise in their yields – was the increased use of derivatives transactions between insurance companies and some banks.

The transactions in question, Forward Rate Agreements (FRAs), essentially allowed insurers to lock in a fixed rate of interest for a future payment, helping to secure specified returns for customers. Foreign banks are said to have purchased long-term bonds on behalf of insurance companies.

Under current standards, the RBI allows FRAs but does not allow bond futures in the Indian government securities market. A bond futures transaction would involve the transfer of a security from the books of one entity in the transaction to another.

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

The growing use of trade stems from the fact that bond yields have seen wild swings over the past year due to the huge supply of debt, rising inflation and the start of the rate hike cycle. of the RBI. Treasury officials said Trade standard that transactions worth more than Rs 2 trillion were linked to FRAs. These trades would have started a few years ago.

Foreign banks would have used such a transaction as a way to bet on rising interest rates and obtain a “carry” or large spread on the corresponding cost of funds – in this case, the pegged swap rate to the day by day over a year.

“Insurers need a mechanism by which they can lock in the current rate of 7.5% or 6.5% or whatever their product rate is. If they want to lock in the rate, they enter into an FRA with a foreign bank. So after a year they lock in a bond yield that is currently prevalent,” said a Treasury official 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 little above the overnight money market or a little above the overnight indexed swap (OIS) market. Then the bank says that since the average financing rate for next year will be 6.10%. 100, she will charge the insurance company 60 or 70 basis points above that. So the bank earns that carry 60 to 70 basis points,” the executive said.

The growing use of the trade comes at a time when other rising rate protection tools, such as floating rate bonds, have seen steep price declines in the secondary market due to heavy supply, traders said.

Foreign banks have increasingly moved to use the FRA product over the past two months due to heavy losses on the highly liquid government-issued 2034 floating rate bond, dealers said. The floating rate note, which is usually a hedge against rising interest rates, has seen its price drop by more than 3 rupees in the past five months due to a glut in paper supply.

“A bank that does an FRA today, going through this complicated mechanism, will probably earn 40 or 50 basis points just by buying the floating rate note,” the foreign bank executive said. “But the problem with the floating rate note is that it’s marked-to-market. And people are not willing to deal with mark-to-market losses.

In April, the media said that the FRA transactions were under the scanner of the RBI and that the central bank had asked some foreign banks to suspend these transactions.

Reports indicate that the RBI rules do not specifically clarify the benchmarking of FRA transactions against securities, such as OIS rates, and that the transaction may have been in a regulatory gray area.

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

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