The Hindu Business Line : Floaters that cut the risk

ING VYSYA is the latest among mutual funds to launch a product that will invest in floating rate bonds. The product is attractive because it lowers interest rate risks. The problem, however, is that such funds do have many floaters to choose from in the bond market. The Reserve Bank of India has only just begun to offer floaters to raise money for the government. And not many companies offer floaters either. The reason is not surprising. Companies prefer certain cash flows. In a volatile interest rate environment, issuing floaters could lead to uncertain cash flows for companies. That would only increase a company's overall risk.

Floating-rate funds, hence, have sizable exposure to fixed-rate bonds. This moderates their investment objectives. Such funds have to, therefore, look to structuring contracts that mimic the cash flows of floaters. Of course, investing in such products will require prior approval from SEBI. But that should not be a problem what with Benchmark Mutual recently showing the way for structured products with its launch of Split Capital Fund.

Structured cash flows: Funds can employ over-the-counter (OTC) products to achieve their investment objectives. One commonly used OTC product is the plain-vanilla swap. In this contract, a fund can swap its fixed-rate cash flows for floating-rate cash flows. ING Vysya Mutual fund, for instance, can enter into a contract with a counter party to swap its fixed-rate cash flows for floating-rate flows. This is the same as investing directly in floating-rate bonds.

The counter party in the swap contracts can be banks and home-loan companies. The latter especially borrow primarily at a fixed rate but lend at a floating rate. Such an asset-liability mismatch exposes these institutions to high interest rate risk.

If interest rate were to decline, a home-loan company will earn lower return on its loan portfolio depending on the benchmark and the reset period. But it may be paying more-than-market-rate on its fixed-rate borrowings. Of course, this asset-liability mismatch works to the institutions' advantage when interest rate are soft such as now. The problem is that going forward, interest rates are likely to be volatile. In such a situation, home-loan companies would prefer to protect their spreads. This can be achieved by swapping the floating-rate loan portfolio for fixed-rate.

Plain-vanilla swap: A floating-rate fund can enter into a contract with a home-loan company. Suppose the fund earns a weighted average return of 7.5 per cent on its fixed-rate bond portfolio. It may credit-enhance its portfolio and agree to pay the home-loan company 6.5 per cent. In return, the home-loan may agree to pay the fund Mumbai Inter-bank Offered Rate (MIBOR) plus one per cent. The portfolio can be credit-enhanced by financial institutions or specialised risk management firms.

Such a deal would be beneficial to both parties to the contract. The mutual fund earns 7.5 per cent on its fixed-rate portfolio but pays only 6.5 per cent to the counter party after incurring 50 bps to credit-enhance the portfolio. Besides, it achieves its investment objectives by receiving cash flows linked to floaters.

The home-loan company also derives some benefit. Suppose this institution earns an average of MIBOR plus 4 per cent on its loan portfolio. Assume that its fixed-rate borrowing cost is 6 per cent. The home-loan company pays MIBOR plus one per cent to the fund but receives MIBOR plus 4 per cent on its loan portfolio. It also gains 50 basis points on the fixed-leg because it pays 6 per cent on its borrowings but receives 6.5 per cent from the fund. The home-loan company, therefore, has a fixed-rate spread of 3.5 per cent.

Two conditions are essential for this strategy to be optimal. One, interest rates should be volatile. Otherwise, counter parties may be unwilling to enter into swaps with mutual funds. Two, the benchmark for loan portfolio and that for the swap should be strongly related. If home-loan companies use prime lending rate (PLR) as the benchmark for their loan portfolio, and if the PLR does not move in line with the swap benchmark, they will be exposed to changing basis. This is the risk that the PLR may not move in tandem with the benchmark used for the swap. Note that the changing basis will not neutralise the benefits of the swap. It will at worst lower the advantages that the home-loan company can derive from the swap contract.

(Feedback can be sent to bvenky@thehindu.co.in)

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