Norms on forwards likely to boost demand for 10-15-year state bonds

Reserve Bank of India’s norms on bond forwards, which will come into effect from May 2, are expected to boost demand for forwards linked to 10 to 15-year state bonds, driven by wider yield spreads over government securities in this segment compared to longer maturities, said market participants.

 

The central bank has authorised the use of bond forwards in government securities—financial contracts in which two parties agree to buy or sell a government bond at a predetermined price on a future date. The move is aimed at enabling market participants, especially long-term investors, to manage their cash flows and interest rate risk.

 

RBI Governor Sanjay Malhotra had introduced this during the February Monetary Policy meeting as part of the initiative to expand the range of interest rate derivative products available to market participants for managing interest rate risks. 

 

The move aims to help long-term investors, such as insurance funds, manage interest rate risk across different cycles, while also enhancing the efficient pricing of derivatives linked to government securities.

 

“The demand for forward contracts linked to SDLs [state development loans] will be in demand,” said the treasury at a private bank.

 

“The 10-year and 15-year segment had a wider spread, I see more demand there as compared to 30 and 40 years and longer tenure bonds,” he added. 

 

The yield spread between 10-year state bonds and the benchmark 10-year government bond stood at 29 basis points.

 

Unlike forward rate agreements (FRAs), which involve no physical delivery of securities, an insurance company using bond forwards for hedging purposes can take direct delivery of the bonds. Previously, settlements were netted by cancelling benchmark rates.

 

“Bond forwards will be a preferred hedge instrument for insurance companies because we as end-investors get the asset delivery with bond forwards. In bond FRA hedges asset delivery is not part of the contract.” said Churchil Bhatt, executive vice-president at Kotak Life Insurance. “Our hedge requirement was met with bond FRAs as well, however, the contracts were cash settled. Hence we had to procure the underlying asset from the market independently. As investors, we would prefer a hedge instrument that helps us procure the asset as well.” he added.

 

Experts said that the regulatory announcement on forward contracts will improve price discovery and expand market participation.

 

Scheduled commercial banks and standalone primary dealers would act as market makers for bond forwards. However, small finance banks, payment banks, local area banks, and regional rural banks are excluded from the category of players allowed to engage in market-making.