Rush hour in interest rate futures market

With the Reserve Bank's rate cuts, daily turnover rises 50%; interest rises across investor classes; mutual funds are expected to raise exposure further

Reversal in the rate cycle has pushed up activity in the interest rate futures (IRFs) market. Turnover in the bond futures market has picked up even with the Reserve Bank of India (RBI) announcing two rate cuts in the first three months of the calendar year.

Data from the exchanges show the daily average value of trades in IRFs this year is Rs 3,096 crore, up 55 per cent from Rs 2,000 crore in the September 2014 quarter. IRFs are currently traded on the National Stock Exchange (NSE), BSE and MCX Stock Exchange. NSE accounts for about 80 per cent of the total market share, BSE about 13 per cent and MCX-SX about seven per cent.

IRFs are securities which bet on the direction of interest rates. The underlying products are the 10-year government security and the 91-day treasury bill. However, the treasury bill instrument sees very little trading interest.

“We have seen a diverse group of investors coming into the IRF market after the rate cut cycle has kicked off. Interest from high net worth individuals (HNIs), institutions like mutual funds (MFs) and even banks has gone up,” said Ajay Manglunia, head of fixed income, Edelweiss Capital.

At present, banks and primary dealers account for a little more than 50 per cent of the total IRF market. MFs, foreign investors and other companies account for a little over 40 per cent. HNIs and retail investors make up less than 10 per cent. Participation by foreign investors is capped at $30 billion, exhausted as of now. Insurance entities are not allowed to participate in bond futures.

The volumes had already been moving up in anticipation of a rate cut announcement. RBI announced two off-policy rate cuts, surprising the markets, as inflation data showed an improvement. The first was in January, ahead of the February policy meet. The second one was announced last week. The next policy review will be in April. The cut, of 25 basis points (bps) each time, enthused market participants, who have started speculating on the trajectory for the rest of the year. Most experts say interest rates would be down another 50 bps before the end of the year.

According to experts, banks and other institutions can gain an arbitrage of three to four bps a month, by buying government securities (G-secs) in the cash market and then going short in the futures market.

For MFs, this translates to returns of 13-14 per cent in schemes investing in IRFs. With RBI expected to cut rates by about 50 bps more, the returns are expected to go further, said Manglunia.

“G-sec yields have gone from 8.65/60 to 7.65/60 at present. Another 40 bps drop in yields could see returns rising by 2-2.5 per cent,” he said.

Also, the instrument in its current format is much more attractive for MFs, as it is traded through the exchange, unlike earlier when it was traded over the counter.

“The risk is lower because here various participants are involved. Also, the liquidity in the current underlying is very good because the focus of the current regime is also on improving liquidity,” said Dwijendra Srivastava, head of fixed income, Sundaram Mutual.

Sectoral officials said with the security gaining popularity since the beginning of the year, many more MFs are expected to increase their exposure to the IRF market. “We are all having internal discussions about the limits available to us and how we can invest through these. MFs could become very serious players in this market,” said a fixed income fund manager of a domestic fund house.

The positional limits for MFs in bond futures is capped at Rs 200 crore or three per cent of the total open interest, whichever is higher.