Interest rate futures not for individuals

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In the past 10 days, we have seen a lot of fuss and analysis around the third launch of interest rate futures (IRFs). Rightly so, because they have been launched in modified avatars twice before, but with little success. This time around experts are touting them to be a game changer with the appropriate product specs.

An interest rate future is a cash settled derivative that will allow you to take a view on which direction the yield of 10-year government securities (G-sec) might move over the next one, two or three months. The underlying bond is the 10-year benchmark government security—at present the 8.83% 2023 G-sec. This is the most liquid bond in the market and reflects sentiment accurately. A derivative on this bond is expected to be used effectively when people either want to hedge a current position or want to trade on sentiment.

Most experts we spoke to are confident that IRFs are a much needed addition to institutional and corporate portfolios, where these can be part of the hedging mechanism. There is also utility in trading when an entity has a short-term view on the direction of rates.

But does this seemingly complicated instrument have utility for the individual investor? Technically, a well-versed investor can use these derivatives in more than one way to aid her overall portfolio.

How does it work?

Bond prices are inversely related to the yield. So, if rates are expected to move up and yields follow suit, then prices will fall, and vice versa. If prices are expected to fall, you can short (sell without owning) the futures. You can buy them or go long if you are expecting yields to fall and prices to rise.

First, you can now use futures to simply trade the view you have. A derivative allows you to take a high exposure on the underlying security with relatively low outflow. Since, these are cash settled there is no ambiguity at the maturity of the contract. Alternatively, you can also use this to hedge your existing bond investments or even an outstanding loan.

Let’s say you have a Rs.50 lakh housing loan and you expect that over the next 3-6 months, interest rates can increase 50-75 basis points. This will increase your outgo on the equated monthly instalment (EMI). To hedge this potential increase in EMIs, you can short the interest rate futures. Taking a short position (or selling) means that if your view is right, you will gain on the futures because bond prices will fall if rates do rise. To undertake this trade you will have to pay a premium, which is your hedging cost. Investors also have to maintain margin money of around 3-5% on trades. The minimum trade size is Rs.2 lakh or 2,000 bonds.

There is another way to look at this. Consider the current scenario: you want to take a loan but rates are high at the moment and you think they can fall in the next 3-6 months. Says Piyush Garg, executive vice-president, ICICI Securities Ltd: “If you want to take a loan today, you can buy the futures. If rates fall, you will gain on that trade and offset the notional loss of borrowing at a higher loan rate.”

Here is another scenario: you have exposure of around Rs.10 lakh in tax-free bonds at a fixed rate. Again, if you are expecting rates in the economy to rise, in a sense there is an opportunity loss for you as you are locked into the tax-free bonds that you hold at a lower rate.

You can offset this opportunity loss by shorting the IRFs as the price of the underlying bond will fall if rates rise.

These are just a few examples of how you can use IRFs for hedging in your personal investments and loans. Garg adds, “There are other trades as well that can be done. For example, you can trade on expectations of a narrowing corporate bond spread. Moreover, it needn’t be restricted to the debt market—change in bond yields impacts banking stock prices. If you are exposed to banking stocks, you can use IRFs to hedge that exposure too.”

Hedging, however, is just one of the uses of IRFs. Siddharth Bhamre, head, derivatives, Angel Broking Ltd, says, “Not everybody will be interested only in hedging. There are people with a view on the interest rate market who will use this to simply trade. No developed financial market is complete without IRFs, which are globally traded in volumes far higher than equity futures.”

How MFs will use this

As of now, mutual funds (MFs) are allowed to use derivatives only for hedging and not trading. Hedging can be beneficial in overall portfolio management as fund managers can now manage a two-way view on the market. Lakshmi Iyer, head, fixed income and products, Kotak Asset Management Co. Ltd, says, “When there is uncertainty on the direction of interest rates, these (IRFs) can be used to hedge an existing exposure. A portion of the portfolio can be hedged so it is not impacted from a move against the view.” She adds that the hedging costs are not high. On the whole, it helps in better management of the portfolio and at the same time doesn’t add too much to the cost.

The advantages may attract more MFs into using IRFs. Says Nandkumar Surti, managing director and chief executive officer, JP Morgan Asset Management India Pvt. Ltd: “The product itself is good. Gradually, fund managers will move in the direction of using IRFs more. But volumes are important and we will have to wait to see how that develops.”

Using IRFs as a hedging tool by MFs will be most useful for long duration funds that carry a relatively high interest rate risk.

Mint Money take

For an individual investor the complication lies in equating an underlying loan or bond holding with the hedge itself. If you want to hedge your Rs.50 lakh loan, how much of the futures should you buy?

This equation is hard to figure out and as Garg puts it, unless you are hedging an exposure in 10-year G-secs, it will be difficult to have a complete hedge as the underlying security is different.

Since, the trade off in case of your loan or tax-free bond or any other fixed income exposure versus the IRF is not linear, you will find it difficult to hedge perfectly.

Plus, derivatives carry risk; if your view on the direction of rates is wrong, you may end up losing more on the futures trade, which will have to be settled in cash. The most important purpose of investing in fixed income securities is to avoid risk. And a loan already adds financial burden, so you wouldn’t want additional risk on that.

It’s early days for IRFs in India. It’s best if retail investors do not get into this market at the moment, till the market liquidity and understanding of the product is more developed.

Even for high net worth individuals, rather than using IRFs to hedge personal exposure, it may work better to use them on the trading front, where one can take a view on the near-term move in interest rates.

At the moment, the recently launched IRFs works only on one underlying bond of a 10-year maturity. Once the market develops to include maturities across the curve, corporates and institutions are likely to increase their usage. For individuals, however, the risks outweigh benefits.

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