India 2005 - First structured issuance
The Indian domestic bond market is brimming with confidence and is seeing a wave of structured bond issues that allow investors to bet on the shape of the government yield curve in the next five years. The deals are a further demonstration of the vibrancy of India’s domestic bond market. Shankar Ramakrishnan reports.
The deals pay a fixed coupon plus the spread between five-year and one-year Indian government securities (Gsecs) and are effectively ways for investors to bet on a steepening of the curve.
The first such deals came in mid-August via HSBC, in the form of a Rs3bn (US$68.5m) four-year from HDFC and a Rs2.5bn five-year from IDBI. The deals pay fixed coupons (5.62% for the former and 5.70% for the latter) plus the spread between five-year and one-year Gsecs – 100bp–102bp at the end of August. That spread is reset semi-annually and is floored at zero.
By the end of the month, an additional Rs6bn of such bonds had appeared, with Indian Railway Finance Corp issuing a Rs3.5bn five-year, Mahindra & Mahindra Finance a Rs1bn three-year and Citicorp Finance a Rs1.5bn three-year. All these bonds paid a fixed coupon plus a spread between five-year Gsecs or five-year overnight swap and one-year Gsecs or one-year overnight swap.
More such deals are on the way, with Power Finance Corp rumoured to be in the market with a Rs5bn five-year issue.
“It is win-win for all involved,” said Dhawal Dalal, head of fixed income at DSP Merrill Lynch Mutual Fund. “On one hand, the issuer is able to raise substantial funds at a competitive cost while investors [expecting the curve to remain steep] can execute their view and get a yield pickup. These are the type of innovations that will keep the Indian rupee bond market vibrant.”
Kaustubh Kulkarni, vice president at ICICI Securities, was also enthusiastic. “This transaction is basically allowing an investor to make a call on interest rates. Based on historical spread movements, it could be a bit aggressive call to make but investors could also be buying it now for the higher initial yield accrual.”
But not all are convinced. Many dismissed the current structure as fraught with risk especially as the government’s yield curve is at an historically high level.
“It is surprising how this structure is gaining momentum among investors even though the spread of 100bp [between five-year and one-year Gsecs] can be considered the top-end,” said one investor. “I am not sure what view is pushing this current spate of issues.”
Another investor added: “India’s bond market is an outright cash market and taking this risk for five years is definitely not worth the effort. Earlier innovative transactions like inverse floaters were only for one-year maturities and asked investors to take a call on interest rates for a short-term. This time around, investors have to make a longer naked call.”
Others suggested that investors were getting sucked in by the high initial coupon. For example, the initial yield of the IDBI trade worked out to around 6.70%, an attractive short-term carry for fixed income funds that pay yields of roughly 5.00–5.70%.
If such trades do begin to look dicey, investors should find it relatively easy to hedge themselves via the swaps market which is fairly liquid and deep, said another banker.
In any case, “Historically when oil price issues impacted the currency, long-end bonds had sold off during the uncertainty and though liquidity is strong in the short-term, one can’t equivocally say that the yield curve will flatten and investors will lose out,” he added.
Broadly, bankers saw these innovative transactions as key to ensure vibrancy in the domestic bond market. Bound by the regulations that come with an economy that is not fully liberalised, the growth of India’s domestic bond market has been restrained. So far in 2005 Indian rupee bond issuance volumes totalled US$8.8bn and though it could manage to match the levels attained in 2004, it may not exceed that, said bankers.
The deals also help banks to generate more income than they would normally earn through regular transactions. “Nowadays, most bond issuers do not pay any fees and even to sell bonds that pay some fees, banks have to pass on incentive payments to investors. Through these structured transactions, the issuer benefits because he gets a fixed cost which is lower while the investor gets a yield pickup and in the process the investment bank makes some money,” said a banker.