Loan futures could bring transparency to lending business: Economic Times: 25th November 2009

The interest rate movements in the past seven months throw up some interesting details. The cost of raising funds for the government as represented by the yield on 10-year paper increased from 6.13% in April to 7.40% in October.
In the corporate debt market, public sector banks paid a premium of between 1.8% in June and 2% in May over the government borrowing rate for a similar maturity. In contrast, private firms, including private sector banks, paid a premium of between 1.9% in October and 4.38% in May for loans of similar tenure. What do these mean?
Firstly, there is a high risk premium attached to corporate debt over government securities which increases with the type of entity. These spreads were much lower within a range of around 2% in 2006-07 before the financial crisis set in.
Secondly, anyone entering the market needs to take a view on interest rates well before the issuance as the corporate debt market is not liquid and there may just not be a secondary market for the same. There is hence a balance to be struck between requirement of funds and the interest rate expectations.
Thirdly, while the cost to a corporate is higher than that for the government, it is still lower than the bank PLR, though banks do not give loans for such tenures. But, still, it is preferable to the PLR-based lending of term financial institutions. Fourthly, both borrowers and lenders carry this risk of rates moving in either direction as when one party gains, the other loses.
A practical solution is the cover available through interest rate future, though ideally options would be desirable. A company which borrows money today at, say, 10% and expects rates to come down after six months can simultaneously lock into an interest rate future, IRF, contract by buying the underlying GSec that can be sold when the price rises and interest rates come down. This would be a useful hedge.
The lender could also take a counter position and hence both the markets would receive an impetus. The existence of the IRF market would make the corporate debt market more buoyant as it would to an extent cover the lacunae of a liquid secondary market. There is a theoretical solution too, even though it may sound unconventional. Today interest rates are fixed based on market perception and not market forces. Usually, it is linked to the existing PLR with an adjustment for the risk involved as well as the expectations of interest rates as these are typically long-term bonds.
A thought worth pursuing is having a derivative market for bond or loan futures wherein there are fixed denomination bonds that are traded on NSE for fixed tenures for a certain grade of rated company. Hence, we could have a bond for Rs 100 crore with a coupon rate of 8% and rated triple A which would be transacted six months down the line. The nomenclature for the same would be AAA 8% May 2010 contract where every contract has a size of Rs 100 crore.
Banks would be the sellers and corporates the buyers though anyone can actually participate on the exchange. The price of the bond would move during these six months and may settle for say Rs 98 implying an implicit yield of 8.16% which can then be taken to be the market determined rate. This innovative product would go beyond the IRF where one is indirectly seeking cover and add a great deal of the market mechanism in interest rate determination.
A successful market for such loan/bond futures would go a step further in providing a view of what the PLR should be from the point of view of the market. This will bring in some degree of transparency into the lending business. Today rates are fixed by banks based on their internal pricing policies which may not be inclined towards the market and loan futures will in a way create a market. Loan futures will address the concerns of the market mechanism and players simultaneously.