The Hindu Business Line : The `when issued' market

The Reserve Bank of India, in its Annual Policy Statement for 2006-07, announced the introduction of a `When Issued' Market for government securities. To appreciate the mechanics of this market, one needs to understand some basic vocabulary of a bond trader.

Long means holding a bond. A government bond (say, 7.59 per cent, 2016) may be trading at a `premium' on account of the interest rate level for the particular tenor being low. Thus, the Rs 100 face value G-Sec carrying a semi-annual coupon of 7.59 per cent may be priced at Rs 101.74 with the 10-year yield dropping to 7.34 per cent. A trader buying the bond at Rs 101.74, and keeping it in his portfolio would said to be `long' at Rs 101.74.

Short means selling a bond when actually you do not hold it. Whereas it is easy to be long on a bond (simply buy and hold), the downside risk is that its price may start falling, if the interest rates begin rising.

Thus, if the government wants to borrow from the market, it announces the auction of the 10-year 7.59 per cent 2016 security. But if the market is expecting the 10-year yields to rise to 7.48 per cent, bidderswould naturally demand a higher yield (close to 7.48 per cent) and be willing to pay only Rs 100.74, instead of the going price of Rs 101.74 and a yield of 7.34 per cent.

The government, thus, ends up paying a higher rate of interest for its borrowing, when the bond market is bearish (that is, the market expects the interest rates to rise).

RISING RATES

Oil prices threatening to touch $100 a barrel, worries about inflation going up, high credit growth, rising asset prices, hardening of international interest rates... all seem to be the right ingredients for higher interest rates.

Add to this the `spice' of the Fiscal Responsibility and Budget Management Act, 2003, which says that, "Reserve Bank of India will not subscribe to the primary issues of the Central Government securities from 2006-07."

One would then be tempted to ask: How much of the primary issues of government securities will the market be required to digest? The answer: Rs 1,13, 788 crore in 2006 -07.

If interest rates are headed up, will the market not throw up all these securities due to indigestion?

In other words, `One who sells first will lose the least,' would be the name of the game at the auctions, and the government would be paying higher and higher interest for each edition, hurting itself and the banks holding government securities in their `Available for Sale' portfolios.

So what is the solution to this disheartening bearish bond market scenario and what instrument can be thought of to make bond traders bid at G-Sec auctions, and fill the vacuum created by the RBI withdrawing from `supporting' the auction, so that the government's borrowing costs do not become too high?

SHORTING

The solution is `shorting' of G-Secs. As described earlier, a `short' is sale of a security which the seller does not have.

So, if Bond Trader A sells 7.59 per cent 2016 G-Sec to Bond Trader B at Rs 101.74, the latter would ask the former for delivery (this is done by transferring the security from A's security account with the RBI to B's; called Security General Ledger or SGL Account).

Since there is no balance in A's account, there would in effect be a `debit balance' in it. But, then, debit balances, or `short' positions, in SGL Accounts are not allowed.

So it is a Catch-22 situation. No. Welcome to the world of `when issued' market. In the above example, suppose the government decides to auction 7.59 per cent 2016.

It announces on April 18, 2006 that the auction would take place on April 28 (when the bids would be accepted) and settlement would be done on April 29. If the current price (for settlement T+1=April 19) for 7.59 per cent 2016 is Rs 101.74 (yield 7.34 per cent) on April 18, the `When Issued' Market would quote a different price for settlement on April 29.

If the current price of the 7.59 per cent 2016 is Rs 101.74, and the majority of the market participants expect the interest rates to rise by April 29, the traded price for settlement on `when issued' basis will start falling and tend towards Rs 100.74, as each participant sells to the other and tries to `remain short'.

Now, on the auction date, if the government auctions Rs 5,000 crore 7.59 per cent 2016, and the market has built up an overall `short position' at, say, Rs 101.14 and yield 7.42 per cent, there would be sufficient bidders at Rs 100.74 and yield 7.48 per cent, as a profit of 40 paise would look attractive.

Moreover, after the auction, the `when issued' market in 7.59 per cent 2016 would cease since the issue would have taken place.

Thus, those who would have gone `short', expecting the G-Sec price to fall and interest rates to rise, would necessarily have to buy the security and `square' positions.

CREATING DEMAND

Thus, from a disheartening scenario of bearish bond markets, where no sane bond trader would have been tempted to buy G-Secs if the interest rates were likely to go up, we will have a situation of a `when issued' market where the Bond traders could go `short' and create sufficient demand for the security when it is auctioned by the government.

What about if it were the other way around — that is, if interest rates are expected to fall?

In the same `when issued' market, the bond traders would go `long' and drive the prices higher and yields lower, and then set a market level at which the `shorts' would have to bid in the auction to deliver the security to the `longs' on the issue settlement date.

Will the `when issued' market take care of the government borrowing programme of Rs 1,13,788 crore, without driving the yields through the roof as interest rates harden? Time alone will tell, as the bulls (longs) and bears (shorts) battle it out in the `when issued' market, and the bystanders wait for the time when shorting will be allowed for the normal secondary market also.

(The author is CEO, Fixed Income, Money Market and Derivatives Association of India.)