Concepts continues with the benchmarks that can be used by Indian corporates for Interest Rate Swaps. Last fortnight, concepts introduced various short term benchmarks that can be used by Indian corporates. This week, Concepts introduces various long term benchmarks that can be used to hedge interest rate risks. The market for long tenor swaps is not as liquid as the short tenor swaps. However, the same can be structured on a one-to-one basis. The various long term benchmarks and their practical uses in the Indian markets are:
Bank Prime Lending Rates
Financial Institutions Prime Lending Rates
Bank Rate
364D Treasury Bill Rate
5 Years Government of India (GOI) security rate
Concepts introduces the benchmarks that can be used for the corporate’s long term borrowings, along with their uses
Prime Lending Rates (PLR) Swaps
Various corporates have long term loans / borrowings in their books, borrowed long time back at high rates of interest, which are not pre-payable. The corporate is stuck with a borrowing, which, when interest rates fall down, can neither be prepaid on mutually negotiable terms nor can the corporate take advantage of the lower interest rates. Interest Rate Swaps can be used to convert a fixed rate long term borrowing into floating rate long term borrowing. Like plain vanilla interest rate swaps, a PLR swap consists of an exchange between a PLR interest cash flow and a fixed rate one. The following example demonstrates it clearly.
A Corporate enters into a PLR swap on the following terms as on 1st January 2001:
Let us assume that the PLR Rates during the first quarter are
1st January 2001 12.00%
1st February 2001 12.50%
On the settlement date, i.e. 1st April 2001, the net payments are calculated as follows: Corporate To Receive:
12.00% for 31 days and
12.50% for 59 days
The floating rate would be calculated as follows:
Corporate To Pay:
12.00% for 90 days
The fixed rate would be calculated as follows:
Therefore the net settlement on 1st April 2001 will be Corporate to Receive Rs. 1,51,98,630/-
Corporate to Pay Rs. 1,47,94,521/-
Net Corporate to receive Rs. 4,04,110/-
Similar calculations would happen on each settlement date till the termination of the swap.
Hence, the corporate saved as the PLR moved up. The following diagram would make the cash flow understanding simple:
But, in the Indian context, the corporate borrower which has borrowed in fixed rate, has lost out due to the lowering of interest rates and loose lending agreements not allowing the corporate to prepay back the loan or pay a high prepayment premium on the same. Indian interest rates have tended to move down over the last 2-3 years and hence, if the corporate would have entered into a PLR swap, where it would pay the PLR and receive a fixed rate, it would have been able to take advantage of the lower interest rates and yet not prepay the loan. The swap can be structured as per the terms of the original loan contracted.
The below graphs demonstrate the history of State Bank of India PLR & ICICI Long Term PLR. The PLRs have
fallen continuously.
Bank Rate
Similar to PLR, corporates can also use the bank rates as their floating rate benchmarks. The graph alogeside shows the movement of Bank rates as declared by RBI in the last decade.
364Days Government Tbill Rates
Corporates can also convert their fixed rate borrowings into floating rate borrowings, which are more market determined. This would help corporates to take advantage of the low interest rates immediately, as against PLRs and Bank Rate, which do not reflect the interest rate scenario till a sustained structural shift has taken place. Corporates can receive a fixed rate and pay 364D Tbill rate as a floating benchmark. The graph shows the movement of 364D Tbill cut-offs, as announced by RBI for the last 4 years.
5-Year Government of India security yields
Like the 364D Government Tbill rates, corporates can also use the Government security yields to take advantage of the floating rate borrowings, in times of lower interest rates. Take an instance, where a corporate has issued 7 year borrowing. After 2 years, the interest rates start falling down. The remaining maturity of the borrowing is 5 years. To take advantage of the falling interest rates, the corporate can enter into a swap where it would receive a fixed rate and pay annualized 5 year Government security rate. Alternatively, a corporate issues 5 year fixed rate debentures, which is at a spread of 100 bps. Since, the rates are fixed, any downward movement cannot be taken advantage of. However, a corporate can enter into a swap to receive the fixed rate equal to the rate on debentures and pay a 5 year GOI security. This would lock in the corporate’s spread at 100 bps over the prevailing GOI interest rates. The graph shows the movement of the 5 year GOI security semi-annual yields.
Concepts reiterates that the corporate should take care of the following points, before deciding upon the
benchmark:
The underlying hedge that the corporate is undertaking the IRS for
Understanding the determination of the benchmark
The benchmark, from a corporate’s point of view, should not be very volatile.
DISCLAIMER
The above views are based on the latest available information. Though the information sources are believed to be reliable, the information is not guaranteed for accuracy. While the views are proffered with the best of intentions, neither the author, nor the firm are liable for any losses that may occur as a result of any action based on the above. The financial markets, and especially the Indian money markets, are illiquid and inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved.
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