 "Valuation gaps in state loans mask treasury losses")
Hardly anyone can be happy investing in bonds these days but for some, life has little mercies.
As yields rise and bond prices fall due to a glut of supply from both the central and state governments, treasury profits are getting wiped out. However, thanks to an archaic rule on how state governments bonds can be valued, the losses are getting understated in the treasury results.
It is a valuation trick and gets nullified when actual sale of bonds takes place, when a bank must book the actual loss. Rules of the Fixed Income Money Markets and Derivatives Association (FIMMDA) say state development loans (SDLs) should be valued at equal maturity government security plus 25 basis points (bps) when trading data is not available. However, the secondary market for SDLs is almost non-existent.
The latest cut-off of a 10-year SDL was as high as 8.55 per cent. This means, the spread between the 10-year government security (G-Sec) and an equivalent maturity is 75 bps (a basis point is a hundredth of a percentage point). However, according to the FIMMDA norms, the bonds get valued in the book at about eight per cent. The extra 50 bps spread, translating to Rs 3 a bond, is a valuation gain in the book, to remain there unless the bonds are sold or traded in the market.
Some money market participants allege this gain is, being used to suppress losses incurred in the government bond portfolio, rising as yields are rising or kept static despite Reserve Bank of India (RBI) rate cuts. The valuation in these bonds has to be based on market prices, as the secondary market is quite robust. The net effect is the bond portfolio looking relatively healthy, whereas it should have shown steep losses.
It is difficult to quantify how much of suppression is taking place in the banks’ books and insurance companies, the primary SDL buyers. It is not a small amount. For example, in the past few months, as the cut-off spread widened in auctions, at least Rs 1 lakh crore of SDLs have been issued. A rough calculation shows the investors were able to suppress about Rs 3,000 crore of losses in their portfolio, taking advantage of the illiquid secondary market and FIMMDA valuation trick.
Business Standard spoke with several bank treasurers and bond traders for this report. Most of them confirmed the loophole and none wished to be named.
RBI is aware of this practice. According to sources, the central bank tried several times to introduce a market-linked valuation for the bonds, to take into account the average auction prices for valuation purposes. However, it could not implement this, in the face of rising yields and mounting losses. Some resistance from investors also helped in keeping the decision at bay for now.
“Multiple securities and less liquid secondary markets are a major cause for such valuations. However, the prevailing condition is not conducive for introducing new changes,” said Soumyajit Niyogi, associate director, credit and market research, at India Ratings.
“G-Sec yields will rise sharply if the valuation leeway is gone. Let the government figure out if they want to borrow at those high coupons,” said another. However, one bank treasurer said, the masking is not much with banks, as the lenders are not major buyers of the SDLs and there is is no point in suppressing the losses, as there is no actual gain.
That may be the case but at the quarter end, the treasury book of banks and insurance companies can still show lower impact of adverse yield movement.
PROCEDURAL LOOPHOLES But losses are getting understated in the treasury results
It is a valuation trick and losses get nullified when actual sale of bonds takes place
According to FIMMDA rules, SDLs should be valued at equal maturity govt security plus 25 bps when trading data is not available
However, the secondary market for SDLs is almost non-existent
As yields rise and bond prices fall due to a glut of supply from both the central and state governments, treasury profits are getting wiped out. However, thanks to an archaic rule on how state governments bonds can be valued, the losses are getting understated in the treasury results.
It is a valuation trick and gets nullified when actual sale of bonds takes place, when a bank must book the actual loss. Rules of the Fixed Income Money Markets and Derivatives Association (FIMMDA) say state development loans (SDLs) should be valued at equal maturity government security plus 25 basis points (bps) when trading data is not available. However, the secondary market for SDLs is almost non-existent.
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Compounding the problem, states do not reissue their bonds but keep issuing new papers at every auction. Consider the 10-year government benchmark bond that ended at 7.72 per cent on Wednesday. If a bank or an insurance company, which bought SDLs, has to value the bonds at book value today, it should be at 7.97 per cent, if the SDL in question has not been traded in the secondary market. This is often the case.
The latest cut-off of a 10-year SDL was as high as 8.55 per cent. This means, the spread between the 10-year government security (G-Sec) and an equivalent maturity is 75 bps (a basis point is a hundredth of a percentage point). However, according to the FIMMDA norms, the bonds get valued in the book at about eight per cent. The extra 50 bps spread, translating to Rs 3 a bond, is a valuation gain in the book, to remain there unless the bonds are sold or traded in the market.
Some money market participants allege this gain is, being used to suppress losses incurred in the government bond portfolio, rising as yields are rising or kept static despite Reserve Bank of India (RBI) rate cuts. The valuation in these bonds has to be based on market prices, as the secondary market is quite robust. The net effect is the bond portfolio looking relatively healthy, whereas it should have shown steep losses.
It is difficult to quantify how much of suppression is taking place in the banks’ books and insurance companies, the primary SDL buyers. It is not a small amount. For example, in the past few months, as the cut-off spread widened in auctions, at least Rs 1 lakh crore of SDLs have been issued. A rough calculation shows the investors were able to suppress about Rs 3,000 crore of losses in their portfolio, taking advantage of the illiquid secondary market and FIMMDA valuation trick.
Business Standard spoke with several bank treasurers and bond traders for this report. Most of them confirmed the loophole and none wished to be named.
RBI is aware of this practice. According to sources, the central bank tried several times to introduce a market-linked valuation for the bonds, to take into account the average auction prices for valuation purposes. However, it could not implement this, in the face of rising yields and mounting losses. Some resistance from investors also helped in keeping the decision at bay for now.
“Multiple securities and less liquid secondary markets are a major cause for such valuations. However, the prevailing condition is not conducive for introducing new changes,” said Soumyajit Niyogi, associate director, credit and market research, at India Ratings.
“G-Sec yields will rise sharply if the valuation leeway is gone. Let the government figure out if they want to borrow at those high coupons,” said another. However, one bank treasurer said, the masking is not much with banks, as the lenders are not major buyers of the SDLs and there is is no point in suppressing the losses, as there is no actual gain.
That may be the case but at the quarter end, the treasury book of banks and insurance companies can still show lower impact of adverse yield movement.
PROCEDURAL LOOPHOLES
- Due to a glut of supply from both the central and state govts, treasury profits are getting wiped out