Use swaps to gain from vanishing interest rate spread: HDFC Bank

Use swaps to gain from vanishing interest rate spread: HDFC Bank

Mumbai: India’s five-year borrowing costs are set to climb faster than one-year rates as the government increases debt sales and investors should use swaps to profit from the move, according to HDFC Bank Ltd.

Five-year rates, currently lower than shorter-term costs, will rise more as the government needs to fund higher spending before general elections due in seven months, said Ashish Vaidya, head of interest-rate trading at India’s third-largest bank by market value.

Traders should enter two simultaneous swap contracts, agreeing to make five-year fixed-rate payments in exchange for a floating rate in one and doing an opposite in the one-year segment.

“The government is expected to boost its borrowings," Mumbai-based Vaidya said in an interview. “The inversion of India’s interest-rate curve should correct and the spread should reach zero in two months."

Five-year swap rates dropped faster than the cost of one-year contracts this quarter, sliding below the latter on 18 July, as falling energy prices eased concerns that inflation will accelerate.

Swaps due in 2013 have slumped 2.07 percentage points from a record high touched 1 July, while those due next year declined 1.41 percentage points.

Swaps are derivatives contracts used to guard against or gain from interest-rate fluctuations and involve the exchange of floating- and fixed-rate payments.

The five-year swap closed at 8.5% at 5:30pm Wednesday, 46 basis points lower than the cost of the one-year contract, according to data compiled by Bloomberg. The spread has already shrunk by 14 basis points after Vaidya forecast it narrow before trading began on Wednesday. The measure was 89 basis points on 15 September, the highest in more than three years. A basis point is one-hundredth of a percentage point.

HDFC Bank predicts the spread between the two rates will narrow in the coming weeks and disappear in November.

Investors can gain from that by entering into a so-called “steepener" trade, which combines two swaps to bet long-term interest rates will rise more, Vaidya said.

They should agree to make five-year fixed-rate payments in exchange for a floating rate in one contract and simultaneously do the opposite transaction in the one-year segment.

Typically, longer-term rates rise because of sales of government bonds, which usually mature in five years or more. All bonds sold by the government in the fiscal year that began 1 April are due to mature only in or after 2013.

India said late on Tuesday that it will sell Rs10,000 crore of bonds this week at an unscheduled auction to meet an “emerging requirement". The sale will boost borrowings in the first half of the current fiscal year by more than 10% beyond the budgeted Rs96,000 crore.

The government said it was advancing a part of the planned borrowing for the second half of the fiscal year.

“The government’s borrowing needs can rise as revenue collections may decline amid slowing growth and smaller company profits," Vaidya said.