Due Diligence. Taking cover against interest rate risk

Most investors fret over the losses they can make in their equity portfolio if the stock market trend turns adverse. But even if you are a risk-averse investor with a portfolio stocked with fixed deposits, small savings and debt mutual funds, your returns are subject to volatility, depending on the movement of interest rates and bond yields.

Equity derivatives, especially index futures and options, are a popular method used by savvy investors to mitigate the impact of stock price declines. Likewise, interest rate futures can be used to take cover against the risk to your portfolio arising from interest rate volatility.

Hedging rate risk

Interest rate futures (IRFs) have been around for a while now, but they were not too popular earlier due to their complex contract design. The contracts were based on a notional 10-year bond with 7 per cent fixed coupon rate. This posed difficulties to investors in finding contracts with coupon rates that matched the bonds they held. Also IRFs were earlier physically settled.

These IRFs were re-launched in 2014, with a single-traded government bond as underlying. These futures are also cash-settled now, removing the other difficulty that users faced. NSE Bond Futures (NBF) are based on six-, 10- and 13-year Government of India Securities. The face value of these futures is ₹100, and each lot is valued at ₹2 lakh. Each future has three serial monthly contracts and three quarter-end contracts.

NSE also offers 91-day treasury bill futures that can be used by those holding short-term fixed income assets. These contracts are, however, illiquid with hardly any trading in this counter.

Muted turnover

The turnover in NBF is also not too robust, probably because these instruments are difficult to understand and use. IRFs worth ₹20,000-30,000 crore have been traded in a month over the past couple of years.

Daily average turnover ranges between ₹300 crore and ₹1,000 crore, but not all contracts are popular.

Trading converges around the contracts on bonds with residual maturity of nine and 10 years, such as 679GS2027 (G-sec with coupon rate of 6.79 per cent maturing in 2027) and 717GS2028 (G-sec with coupon rate of 7.17 per cent maturing in 2031).

Since these are future contracts, you have to pay margins that amount to 8-10 per cent of the contract value initially. There will also be daily mark-to-market margins that will be added or subtracted from your trading account balance.

How to use

The price of the NBF tracks the underlying bond price, rising and falling with it. Since there is an inverse relationship between the yield and the underlying bond prices, the future’s price moves higher when bond yields decline and vice versa.

If you are worried about the bond yield moving higher, thus reducing the NAV of your debt mutual fund holdings, you can short bond futures so that the profit from the hedge can help cover the erosion in your fund value. For instance, if you hold debt mutual funds worth ₹4 lakh, you can sell two lots of NSE bond futures.

If the value of your mutual fund declines due to rising yield, the short position in the bond futures will turn profitable when yields increase, thus mitigating the loss.

Similarly, investors with other fixed-income holdings such as bank fixed deposits or small savings investments can also consider this avenue to hedge.

While deposit rates are not tightly linked to bond yields, they are positively correlated. If you expect falling interest rates to hurt your fixed-income return, you can buy NBF, which will profit in falling interest rate conditions.

Those who have sizeable loans also stand to lose when interest rates are volatile. For instance, when interest rates move higher, the interest outgo on your loans will move higher too.

You can neutralise this additional outgo by selling NSE bond futures.

Apart from these, traders can now use IRFs for pure directional calls on interest rates, too. For instance, if you think the RBI is going to reduce repo rate in the monetary policy meeting next week, you can go long in the interest rate futures, and vice-versa if you think the rates can be increased.

COMMENT NOW