Derivative Bond Trade Worth $19 Billion In India At Risk From Govt's Proposed Tax

The transactions enabled insurers to lock in future yields without enlarging balance sheets, and by some estimates account for $19 billion worth of sovereign bonds purchased by banks

A proposed tax by the government may risk India’s derivative trade that boosted demand for sovereign bonds by billions, according to a report by news agency Bloomberg. According to the report, the proposed tax will put pressure on a market straining under record government borrowings.

The transactions enabled insurers to lock in future yields without enlarging balance sheets, and by some estimates account for $19 billion worth of sovereign bonds purchased by banks. If the demand plummets, pressure may mount on the Reserve Bank of India (RBI) to support the market as Prime Minister Narendra Modi increases debt sales.

Citing analysts, Bloomberg said the plan to tax high-value insurance policies will reduce demand, leading the industry to cut back on bond investments. For the past two years, banks have boosted the amount of debt bought for interest-rate swaps offered to insurers.

The government debt purchases due to the trade may drop by 15 per cent to 20 per cent with the tax change, according to Ashhish Vaidya, head of treasury at DBS Bank in Mumbai.

Along with the increase in national borrowings, there’s going to be “a demand shortfall of Rs 2.5 lakh crore which will require either the RBI stepping in or flows from fixed-income real money funds,” he said.

The trade, known as a bond forward-rate agreement, has led to robust demand for long-tenure bonds in recent months. While the yield on the benchmark five-year debt surged more than 140 basis points last year, it only rose by 39 basis points on the 30-year note.

The rate agreement works by insurers locking in yields offered on long-tenure debt — typically 10 to 40-year bonds — for the next two to six years, according to HDFC Life Insurance Co. That eliminates the risk of fluctuating rates. Banks get a spread over their cost of funds and hedge by buying the debt.

The notional outstanding amount of bonds held by banks offering the deal may be around Rs 1.6 lakh crore ($19 billion), according to ICICI Securities Primary Dealership Ltd. and Star Union Dai-ichi Life Insurance Co. The trade, which has further picked up in recent weeks ahead of the tax change from April, is cash settled, according to traders.