Banks cut bond deals to boost profits

Strike Off-Market Transactions In Illiquid Papers Ahead Of Year-End Closing

A SUDDEN surge in traded volumes of a few illiquid bonds could well be an indication that some banks are cutting cosy deals at off-market prices to prop up profits before the current financial year ends.
    Bond dealers are attributing the unusual interest in a few state government-guaranteed bonds to such structured transactions, better known as 'sell/buy deals' in the market. This is how it happens:

• Step 1. Bank A strikes a deal with another bank or a bond house to sell a security at a price which is well above the market rate. Suppose Bank A had bought the security at Rs 100 — the cost price in its trading book. With the market moving up, Bank A spots that the paper is trading at Rs 101.

• Step 2. The bank can make a decent profit by selling the paper at Rs 101. But since it wants to make higher profits, it sells the security to another bank (or possibly a bond house) at Rs 102.50.

• Step 3. On the same day, Bank A buys back the security from the entity it sold to at Rs 102.60.
    Thanks to an opaque market and its strange rules, both parties gain from the two-way deal. How? Bank A earns a profit of Rs 2.50, instead of Re 1 on the security. More significantly, when it buys back the security on the same day, the paper is parked in the held-to-maturity (HTM) basket in its investment portfolio. Till then, the security was lying in the trading basket of the portfolio. The crucial difference is that securities classified as HTM are not mark-to-market (MTM). So, any depreciation in value does not impact the bank's profits. However, in a trading portfolio, full MTM impact is felt by the bank. Central govt secs are more popular
SO, Bank A not only makes an abnormal profit from the deal, but also derisks the security by parking it in a basket which is free of MTM accounting. On the other hand, the bond house or the bank earns 10 paise (the difference between Rs 102.50 and Rs 102.60) by simply being part of a quick deal.
    "In the past, RBI used to call up institutions to find out about such deals...but of late, it seems to have turned a blind eye to all this," said a senior officer of a primary dealer. According to a trader, banks were also buying perpetual bonds of other banks at offmarket rates. Interestingly, even though Bank A (in the above example) buys back the security at a slightly higher price, it does not suffer a loss on account of this. The buyback is actually treated as fresh investment by Bank A, while the profit is made by selling it at a higher price.
    State government securities have traditionally been less popular in the bond market compared to the central government securities, when it comes to daily trading. This has always made them relatively less liquid — except on days like last Monday — when these papers made up nearly a third of the volumes of all the securities traded.
    For instance, data disclosed by the Clearing Corporation of India show that volumes in the 9.38% West Bengal paper maturing in 2018 were as high as Rs 550 crore each on Friday and Monday. This is a paper which has been rarely traded. Traders said such huge volumes in a single paper are extremely rare.
    Total volumes in state government papers hit Rs 1,641 crore and Rs 1,316 crore, respectively, on the two days. However, volumes in this segment were as low as Rs 100 crore on Wednesday.
    Dealers said a Fimmda regulation also comes handy in such trades. The particular rule allows state bonds to be valued at a spread of 25 basis points to the central government security of similar tenure. For instance, if a central government security is trading at 6.80%, the state bond could be valued at 7.05% for year-end accounting. When most 10-year state papers are quoting at a yield of 8.4-9%, this is an artificial rate. (Bond prices go up when yields fall and vice versa).
    sangita.mehta@timesgroup.com