Every thing you want to know about Indian bond market but were afraid to ask

The Indian bond market is vertically split between foreign banks who make profits trading government securities, and state-owned banks that have 70% market share in banking assets

A senior executive of an old private bank who had spent many years in a large state-owned bank’s treasury was all smiles last week, narrating to me what happened in the bond market on 3 April. “The foreign banks were begging for securities... They were shorting the market, bringing down the prices. How long the public sector banks would tolerate that and make losses? Why would they lend securities to the short sellers to meet their delivery obligations?” he asked. The short selling and short squeeze that the market witnessed were hotly debated early this month at the Fixed Income Money Markets and Derivatives Association’s annual offsite in Sydney which this gentleman attended.

My last week’s column dealt with this in detail (The untold story of India’s bond market, 17 April). At the moment, the Indian bond market is vertically split: On the one side, are the foreign banks and primary dealers who make profits trading government securities and, on the other, are state-owned banks that have roughly 70% market share in banking assets and believe in holding on to their bond portfolio to earn coupon or a periodic interest payment earn during the time between the issuance of a bond and its redemption.

The intense fight between the two groups (or, bulls and bears) came to the surface in March, the last month of the financial year 2017, and April, which marks the beginning of a new financial year.

The timing is critical to appreciate the development. All banks in India need to mandatorily invest 20.5% of their net demand and time liability or NDTL, a loose proxy for their deposits, in government bonds and many hold even a larger bond portfolio. The mandated 20.5% holding can be kept in the so-called held to maturity or HTM segment, insulating it from the movement of the bond prices in the market. However, the rest of the portfolio—kept in the so-called available for sale (AFS) and held for trading (HFT) baskets—needs to be valued in accordance with the prevailing market price or marked to market.

As the financial year draws to a close, treasury managers in public sector banks would always be happy if the prices rise as that prevents the mark to market losses. If the prices go down below the price at which the bonds were bought, the banks are required to set aside money or provide for the notional loss. So, they buy heavily and the demand for bonds leads to a rise in the prices. The foreign banks and primary dealers go short—meaning, they sell the securities which they do not own. The selling pressure brings down the prices and hits the public sector banks hard.

In the beginning of a financial year too, we often see a repeat of this. There are a couple of reasons behind this. Unlike the foreign banks and even the private sector banks where one spends decades on the treasury floor understanding the nuances of the business, in most public sector banks, treasury is among several divisions where one would spend a few years before being transferred to another. Typically, this transfer takes place in May-June and the treasury managers want to say goodbye with a winning note. This means, they buy heavily leading to the rise in bond prices.

Besides, the Reserve Bank of India (RBI) every year gives all banks one opportunity to reshuffle their bond portfolio—shifting securities from the HTM basket to the AFS and HFT baskets. This typically happens in the beginning of the year. The banks can also sell securities from the HTM basket but only up to 5% of the portfolio. If they cross the limit, then the entire HTM portfolio becomes vulnerable as it would need to be marked to market.

The bond dealers in foreign banks, by being there for decades, know exactly what the state-run banks’ treasury managers are up to at different parts of a fiscal year and accordingly, they plan their actions. For the first time on two successive occasions in March and April, we have seen the public sector banks ganging up and launching a counter attack.

On both occasions, the banking regulator stepped in and brokered a truce, but how do we prevent recurrence of such ugly fights that threatens the stability of the bond market? As on 31 March, the total outstanding government securities (both central government as well as state development loans) were around Rs47.5 trillion and close to 60% of this or Rs28.63 trillion was being held by commercial banks. Insurance companies, provident funds, pension funds, mutual funds, primary dealers and cooperative banks also buy government bonds. Even though banks buy the bonds to meet their statutory liquidity ratio or SLR obligation, there is not much of liquidity in the market as the banks and insurance companies mostly buy them but don’t trade.

The challenge is to get liquidity across the yield curve. Former RBI governor Raghuram Rajan in 2016 tried to use the primary dealers (there are 21 of them) to play the role of market makers by giving two-way quotes for four securities each but that experiment has not been a success. Lifting the 5% limit on sale of securities from the HTM basket and doubling it to 10% may help in creating liquidity in the market. Banks need flexibility in managing their bond portfolio as anyway they are forced into directed bond buying in an imperfect market where yields get manipulated even by the regulator at times to bring down the cost of government borrowing. Bringing down the HTM portion will force the banks to trade bonds and create liquidity but this may end up creating too much volatility which the banks may not be able to handle.

I understand that the department of financial services in the finance ministry is in favour of ending the SLR requirements that forces banks to buy bonds and curbs their ability to lend. The N.K. Singh committee that reviewed the rules on fiscal discipline has in its report also advocated paring SLR. Indeed, it has been progressively coming down—from 38.5% of deposits in early 1990 to 20.5% now—but unless the fiscal deficit of the government comes down, the SLR requirement cannot come down dramatically. The government has pegged the fiscal deficit at 3.2% of India’s gross domestic product in 2018 and after adjusting for buyback of bonds, the net borrowing programme in 2018 remains almost unchanged from the previous year—Rs3.48 trillion. Without the adjustments, the net borrowing is Rs4.23 trillion and the gross annual borrowing Rs5.8 trillion.

Most Indian banks have made treasury losses in the last quarter of fiscal 2017 but overall, it has been a great year for treasury managers. Between 1 April 2016 and 31 March 2017, the benchmark 10-year bond yield dropped from 7.45% to 6.68%. After fiscal year 2009 when bond yields dramatically dropped following an ultra-loose monetary policy by the RBI in the aftermath of the collapse of iconic US investment bank Lehman Brothers Holdings Inc., both 2015 and 2017 have been great years for the treasury managers. However, unlike Indian farmers who always pray for a good monsoon for a bumper crop, bond dealers cannot forever look for a drop in yield and rise in prices to make money; they need to build expertise in risk management.

Indeed, the short sellers in the bond market spoil the party of the public sector banks but the public sector banks have the crutches of HTM to ward off the adverse impact of the rising yield while foreign banks typically mark to market their entire bond portfolio following international practice. The state-owned banks also have a much a larger bond portfolio to move the market. Moreover, there have been occasions when these banks managed to convince the banking regulator to allow them back dated transfer of securities from AFS to HTM to shield them from the impact of rising bond yields. It happened in June 2004 when the yield rose some 75 basis points in May-June (from 5.16% to 5.92%) and also in August 2013 after a 200 basis points rise in 10-year benchmark bond yield (from 7.15% to 9.15%). On both occasions, the RBI bailed them out.

All bond dealers are expected to follow the principle of PVBP (price value of 1 basis point) on a continuous basis or remain aware of the risk that a 1 basis point movement in yield poses to the bond portfolio. Do all dealers in the state-owned banks follow this? If they do, then why did they buy the long-dated securities in January-February when the banks were flush with fresh deposits (and hence they had to invest in bonds) because of the demonetization drive but they knew well that the bulk of those deposits would flow out soon (and this would bring down their SLR requirement).

While the bond dealers in the state-owned banks need to appreciate the finer aspects of risk management, the aggressive short sellers must be forced to pay a higher price for taking risks. This can be done by introducing negative interest rates when they borrow securities from others in the market through the repo or repurchase deals on the Clearcorp Repo Order Matching System or CROMS platform of Clearing Corporation of India Ltd. Currently, CROMs does not have a provision for a negative interest rate for repo deals but I am sure that the software can be tweaked to introduce this.