Bond yield curve flattens amid surge in forward rate agreement purchases

Traders in bond market have observed a major flattening of the yield curve, attributed to heightened demand for long-term government bonds fuelled by forward rate agreement (FRA) purchases, particularly by foreign banks. The surge in demand has led to a contraction in the yield spread between benchmark and longer-tenure bonds, marking the lowest level recorded in a year.

Foreign banks' interest in FRAs, contracts allowing parties to fix rates for future dates, has been a key driver behind the recent surge in demand. Insurers, seeking to meet asset-liability management requirements and hedge interest rate risk, have also accelerated their purchases of longer-tenure bonds, particularly as government bond auctions approach their conclusion.

Rahul Bhuskute, Chief Investment Officer at Bharti AXA Life Insurance, highlighted the strategic approach of insurers in front-loading their bond purchases, with a focus on fulfilling their ALM requirements ahead of the financial year-end on March 31.

India's 10-year benchmark bond yielded 7.13% on Wednesday, while the 30-year and 40-year notes hovered around 7.19% each. The narrowing spread of 6 basis points between these bonds is the tightest recorded since February last year, indicating a flattening bias in the yield curve expected to persist until the end of March, according to Bhuskute.

Traders noted a surge in interest in FRAs, attributed to a decline in overnight index swap rates and revised investment limits for foreign banks. A central bank draft circular issued in December, permitting market-makers to take long positions in bond forwards without limits, has further stimulated market activity.

Niraj Kumar, Chief Investment Officer at Future Generali India Life Insurance Company, underscored the attractiveness of FRAs for hedging interest rate risks in the current environment. FRAs are seen as the most lucrative option for insurers, leveraging higher yields due to a widening bond-OIS spread.

While official data on FRA trades remains unavailable, traders estimate outstanding FRA contracts to exceed Rs 2 lakh crore currently. Foreign banks have reportedly been active buyers in the bond market, with net purchases totalling Rs 68,500 crore this year, a significant portion of which could be attributed to FRA transactions.

(With Reuters inputs)