The Hindu Business Line : Bond portfolios go for a toss

THE bond market is fixated on just one statistic - the inflation rate that is released every Friday at noon. And this has been rising, quite sharply in fact, from 5% levels to over 6.5% last week.

And quite properly and promptly, traders have marked down bond prices. The yield on 10-year gilts is now well past 6% in the vicinity of 6.25%. Those beyond 10 years are the worst hit. Prices have dropped further, and liquidity is poor.

It is a sad story. For quite some time now, banks have kept more than the mandatory 25% - the Statutory Liquidity Ration (SLR) - in Government securities. Both SLR as well as the investment over SLR have been weighted towards long-dated securities. This was fine when the going was good, i.e. when interest rates were falling. Over a period of five years to 2003, yields on 10 years crashed 6% from 11%. Banks made hefty gains on their gilt portfolios and treasury profits became the mainstay. Most of the improvement in their capital ratios in recent years emanated from the profit windfalls of falling interest rates flowing straight to Tier I capital.

In the last couple of years, the RBI has been cautioning banks of the interest rate risk in their investments. Rates will start to rise sometime, it warned. They were asked to provide for a rainy day through an investment fluctuation reserve. But having tasted easy money, it was difficult to wean banks away from their addiction to gilts. They are paying the price now with yields on 10-year G-Secs soaring 1% in the space of weeks.

Portfolio losses arising from mark-to-market requirements are bound to be substantial.

While the RBI's advice on reducing investment exposures was commendable, in practice, its actions actually increase systemic risk. Most of the primary issues of G-Secs are long-dated ones - 15 years and more - carrying fixed coupons, which are most vulnerable to rising yields. Its issuance of floating rate bonds, whose coupons would adjust upward immediately when interest rates increase and insulate banks from rising yields, has been pitifully small. Thus, the central bank is not entirely free of responsibility for the present woes of banks. (Read `Need for medium-term CDs and floating rate gilts' dated April 4, 2000, and `Curbing rate risk in bank balance sheets', dated April 12, 2000).

It is difficult to understand the reluctance to step up the issue of floaters, given the lack of depth and liquidity of the bond market and its lemming-like behaviour - all are buying or selling at the same time.

Banks are learning their lessons the hard way but one supposes it is better late than never.

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