Government To Limit Floating Rate Bonds To Under A Tenth Of Borrowings

The strain in the bond market, which has led to a series of partially failed auctions, has left the government's floating rate bond issue unscathed. This, as investors try to protect themselves from interest rate risk which may emerge from a turn in global and local inflation conditions.

The government, however, is not keen to raise the share of floating rate debt in its portfolio fearing a rise in payouts should interest rates rise.

As per our debt management strategy, we can keep the share of floating rate bonds at 7 (+/-3)%, said a Finance Ministry official, speaking on condition of anonymity. We cannot go beyond that, this person said. The limit on floating rate debt has been specified because these borrowings can prove costly if interest rates start rising.

The interest rate on floating rate bonds is linked to an underlying benchmark. For instance, the current series of floating rate bonds are priced as a 122 basis points above the weighted average yield of 182-day treasury bills over the previous three auctions. This helps protect investors in the case of any sharp rise in underlying interest rates. On the flip side, it means that the issuer will have to pay higher interest on this share of borrowings.

The government auctions floating rate bonds in tranches of Rs 4,000 crore every alternate week. According to data compiled by BloombergQuint, in the April-June quarter 9% of total competitive bids accepted in government auctions were for floating rate bonds.

The bid-cover ratio for these securities has been between 3-6 times compared to 2-3.4 times overall across the auctions. The bid-cover ratio reflects the amount of bids received compared to securities up for auction. A higher bid-cover ratio suggests stronger demand.

The strong demand for floating rate debt has been replicated in the corporate bond segment as well.

According to a Bloomberg report, issuance of floating rate corporate notes jumped 86% to Rs 23,760 till the end of June, a record for the period, even as offerings in the broader local corporate bond market as a whole have declined by about 17%. Sales of floaters in June are at their highest for any month since April, Bloomberg reported.

The government, however, remains cautious.

Floating rate bonds may be getting good response but it also has interest rates risk with it, the official quoted above said. The government may "experiment" a little bit but it is mindful of the risks that come with FRBs, the official said.

An instrument like a floating rate bond always has better traction at the cusp of a reversal in the interest rate cycle, said Soumyajit Niyogi, associate director at India Ratings & Research. "Specially at the bottom of the interest rate cycle, floating rate bonds hold more appeal, because your interest rate will be reset according to the rising rate scenario."

Niyogi, however, added that in the current situation, the Indian yield curve is particularly steep. The yield on the 364 treasury bill is around 3.5%, whereas the 10-year yield is 6.1%.

"As such, the FRB investor has to take a view on the evolution of liquidity conditions because interest rates will be linked to the treasury bills. So, if there is a chance that liquidity might start normalizing then there is more scope that the shorter-end of the curve to inch up than the longer-end of the curve, Niyogi explained. "If the view on this is clear, FRBs would get good traction from an investor’s point of view."

The Reserve Bank of India has flooded the system with liquidity which has brought down short term rates to even below the policy repo rate of 4%. Longer term rates have remained relatively elevated even though the central bank has intervened to keep yields in check.

However, elevated inflation, if it persists, could push up rates. This could subject investors to what is know as 'duration risk', which reflects the fear that longer term rates could rise.

"Overall, when market is worried about duration risk and wants to be invested in the very short-end tenors, floating rate bonds is a good product to issue to minimise the interest rate risk in the market. I see demand for floating rate bonds continuing to be reasonably strong in current circumstances”, according to Abhishek Upadhyay, senior economist, ICICI Securities.