By Khushi Malhotra and Dharamraj Dhutia
MUMBAI (Reuters) -India’s upcoming bond forwards are set to boost demand for state debt and lower borrowing costs for sub-national issuers, a move investors say could help deepen the country’s local bond market.
The Reserve Bank of India announced guidelines for bond forwards in February, with rules set to take effect from May 2.
While the contracts cover both federal and state bonds, investors expect stronger demand for state bond forwards due to their higher yields.
“Insurance companies would be looking to use state development loans (SDLs) as the underlying for bond forwards with the objective of yield enhancement,” said Ketan Parikh, head of fixed income at ICICI Prudential Life Insurance, adding that this would create demand for state bonds and help them borrow at more affordable costs.
Indian states have emerged as major borrowers in recent years, with their debt levels approaching those of the federal government.
While New Delhi plans to raise 15.82 trillion rupees ($185.93 billion) this year, state governments are expected to borrow around 12.50 trillion rupees, according to ICICI Securities Primary Dealership.
The 10-year notes were issued at around 6.71%, compared to 6.41% on federal bonds of similar maturity at the latest auction of state bonds.
The RBI introduced bond forwards after insurance companies increasingly turned to unregulated forward rate agreements (FRAs) to hedge interest rate risks.
Unlike FRAs, which involve only cash settlement of price differences, bond forwards require physical delivery of the underlying securities.
Three bond market participants said insurance companies—owing to their long-term liabilities—are expected to dominate this new market segment, though the product could attract a broader set of investors over time.
“Bond Forward product will appeal to a wider set of investors, who may want to either, similarly hedge their interest rate risks, or take positions based on their view of interest rates,” Badrish Kulhalli, head of fixed income at HDFC Life Insurance said.
Investors said demand for bond forwards linked to 10–15 year state bonds is likely to be stronger, given the wider spreads in that segment compared to longer maturities.
The 10-year state-central bond yield gap stood at around 30 basis points last week, while 30-year yields were at parity.
The availability of forward contracts will also help stabilise the additional spreads that investors demand from states.
“In the long run we could see spread compression or every time spreads widen, we would see demand coming from insurance companies,” ICICI Prudential’s Parikh added.
