With markets regulator SEBI spelling out norms for mutual funds to use interest-rate futures (IRFs), fund managers are expecting to manage risk in debt portfolios better. Unexpected interest rate movements are a source of risk for any fixed income portfolio. With IRFs, managing that risk becomes easier. This has implications for investors, who are slowly but surely being attracted to debt fund products amid a secular drop in bank deposit interest rates.
Brass tasks
Interest Rate Future is a derivatives contract with an interest-bearing instrument as the underlying asset. In 2013, SEBI allowed cash settled Interest Rate Futures (IRF) on 10-year Government of India (GOI) security.
Debt fund managers use IRFs to enter into an agreement to buy or sell the value of an underlying debt instrument at a specified future date at a price that is fixed today. Exchange Traded Interest Rate Futures are standardized contracts based on a GOI security.
Recently, SEBI has allowed MFs to use Interest Rate Futures (IRFs) to hedge part of the debt portfolio from interest rate volatility on the basis of overall duration of the underlying MF scheme.
IRFs are currently available for 5-yr , 6-yr , 9-yr , 10-yr , 12-yr & 13-yr GSecs which would enable MFs to hedge part of the illiquid bond positions ( part Interest Rate Risk ) across various categories of debt schemes.
What's in it for you
Prashant Pimple, Senior Fund Manager - Fixed Investments, Reliance Mutual Fund told Value Research: "Participation of MFs in IRF segment would certainly result in increase in volumes of IRFs going ahead. Use of such hedging tool would certainly help investors in terms of enhancing returns over medium to long term as it can be used as an active tool to hedge illiquid bond positions across various schemes."
Earlier debt fund managers had to have the specific security to use IRFs. So, IRF use was limited to specific securities. Now, to reduce interest rate risk in a debt portfolio, mutual funds can hedge the portfolio or part of the portfolio (including one or more securities) on weighted average modified duration basis by using IRFs. This a major positive as it allows them to use IRFs to lower portfolio level risk in a better way. Its also good from a risk management point of view. Lakshmi Iyer, Chief Investment Officer ( Debt) & Head Products, Kotak MF says: "So earlier only if you had any of these securities - you could short them in IRF for hedging. Now even if you don't have any of these, you could still hedge your portfolio."
There are more benefits.
Till now fund managers could hold only Interest Rate Futures of a security if they had the same security in the underlying portfolio. Saravana Kumar, Chief Investment Officer, LIC MF revealed that now fund managers can hold imperfect hedged IRFs up to 20% of net assets of the scheme. "They may hedge the portfolio or part of it including one or more securities on weighted average modified duration basis by using IRFs. This is a great step by SEBI because it will not only reduce interest rate risk in the portfolio but also increase liquidity of the MF schemes."
Liquidity of the debt schemes is as important. Liquidity of the scheme depends on the securities held. If a debt manager wanted to lower duration previously, he/she could face trouble on liquid investments aspect. A fund manager who employs a duration strategy is one who takes a call on the direction of interest rate movements and accordingly focusses on adjusting the duration of his portfolio to maximise returns. New SEBI norms allows to hedge based on duration strategy. "For instance, if somebody is running a duration of 5 years, and wants to reduce it to 3 years -- earlier they had to sell bonds to reduce duration, in the process he/she sold the most liquid bonds. So although you lowered duration, you were also left with illiquid bonds. Now with IRFs, just hedging makes the entire duration-cutting exercise much more efficient," explains Alok Singh, CIO, BOI AXA Investment Managers.
Since no selling of bonds is involved, fund managers could also theoretically suffer no adverse impact cost (even a 5 paise bid-ask difference can make a dent).
Kumar of LIC MF pointed out that SEBI norms help imperfect hedging with IRF use with flexibility. "...SEBI has allowed imperfect hedging without it being considered under the gross exposure limits, provided the correlation between the portfolio and the IRF is at least 0.9 at the time of the initiation of hedge. Moreover in case of deviation also, there is a 5 days time period to rebalance the same. This provides lot of flexibility to fund managers with respect IRF based hedging which wasn't available earlier," he remarked.
Hedging costs with IRFs
There are definite costs for hedging with IRFs. The minimum initial margin for cash settled interest rate future contract is 1.5% of the value of the contract subject to minimum of 2.8% on the first day of trading. The same for 91-Day T-Bill futures contracts is minimum of 0.10% of the notional value of the futures contract on the first day of trading and 0.05% of the notional value of the futures contract thereafter will be scaled up by look ahead period.
Then, there are applicable extreme loss margin. This for cash settled interest rate futures contract would be 0.50% of the value of the gross open positions of the futures contract.
Plus, there are other costs like brokerages. "Hedging costs are not significant as much as the benefits. If you look at the benefits, it's clear why hedging with IRFs is a good step," says Lakshmi Iyer of Kotak MF.
However, some fund managers are cautious about hedging costs. This is because IRFs are not a hugely liquid market with many participants. Since mutual funds manage investors' money, the managers want to lower costs of doing transactions. This is because returns will get impacted due to additional costs.
Hedging costs with IRS (Interest Rate Swap) is about 5-6%. Killol Pandya, Head- Fixed Income, Peerless Funds Management Co. Ltd. said: "The cost of hedging through IRF (for 10 year which is most liquid) will be about 25 bps. For mutual funds which are essentially a pass through vehicle, incurring any extra cost means it will finally be borne by the investor. This is why incurring any extra cost has to be well reasoned and justified."
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