Floating rate bond signals interest hike?

Floating rate bond signals interest hike?

Mumbai: The Reserve Bank of India (RBI) is set to issue a floating rate bond on Friday, after a gap of four years, and many bond dealers say this is an indication that interest rates will rise sooner rather than later.

The last time such a floating rate bond was issued was on 25 January 2005. So far, nine such papers are in circulation worth Rs41,350 crore, although they are not traded in the market.

“RBI comes with these papers in a rising inflation scenario," said J. Moses Harding, head of fixed income at IndusInd Bank Ltd.

In January 2005, when the last floating rate bond was issued, inflation was close to 6%. RBI soon started tightening its monetary policy and its policy rate peaked at 9% in August 2008, before the central bank reversed its stance to help aid the recovery of the slowing economy, hit by an unprecedented credit crunch.

Unlike a fixed rate bond, the interest rate of a floating rate bond is pegged to a benchmark, such as the treasury bill rate, and adjusted periodically.

In a rising interest rate scenario, the yields of the bonds held by banks go up and their prices drop. This forces banks to book mark-to-market (MTM) losses, which dent their profitability. MTM is an accounting practice of valuing investments at a prevailing market rate and not the historical rate at which they are bought.

Since the interest rates of floating rate bonds get adjusted periodically, banks will be spared from booking MTM losses if they invest in these bonds. “In a rising interest rate scenario, banks and primary dealers do not get excited about buying fixed rate bonds for fear of MTM losses, but they feel comfortable with floating rate bonds. To that extent, by issuing a floating rate bond, RBI is giving a signal that rates will go up," said an executive with a primary dealer that buys and sells bonds.

Although RBI is issuing a Rs2,000 crore, 11-year paper, the success of this auction will enthuse the central bank to float many such papers. The coupon of this paper is linked to the coupon of 182-day treasury bills. It will be pegged at 3.79% for the first six months. The coupon will be reset every six months, in accordance with the average yields of the last three auctions of 182-day treasury bills.

With wholesale price-based inflation jumping to 4.78% in November from 1.34% in October, economists expect the central bank to tighten monetary policy by sucking out liquidity from the system and raising rates.

“This is a good paper for banks to manage their asset-liability mismatches and will help them hedge against rising interest rates," said Pradeep Madhav, managing director of STCI Primary Dealer Ltd.

“It (floating rate bonds) was a demand in the market for long. RBI is just meeting the demand," said S. Sridhar, head of treasury at Axis Bank Ltd.

Such issuances also make sense for the government as it is raising 11-year money at six months’ rate. The yield on a 11-year paper is at 7.76% now, much higher than the coupon offered for the floating rate bond.

The government is borrowing a record Rs4.51 trillion in the current fiscal to bridge a 6.8% fiscal deficit and many economists believe that the government will be required to borrow such a huge amount in the next fiscal too.

According to G.A. Tadas, managing director of IDBI Gilts Ltd, the central bank will assess the acceptability of Friday’s paper before issuing more such paper. “The problem with floating rate papers...is that investors buy it and don’t trade," he said. This is because there is no chance of a loss in such debt.

Historically, floating rate paper has not been a success in the secondary market, but dealers said greater availability of such bonds, which could be a necessity in a rising interest rate scenario, will prompt trading in this type of debt.

“If the acceptability of this paper turns out to be good, many such issuances might come and older papers could be reissued. Depending on the liquidity of floating rate papers, anybody who will have asset-liability mismatches will trade these," said STCI Primary Dealer’s Madhav.