Impact of movement in interest rates on Bond Portfolio of a

bank and Strategies to increase return on Fixed Income

Securities
By
Abhinav Bajpai

Guides
U V Rajani Kantha Rao, AGM, Treasury Branch, Central Office, Union Bank of
India
&
Prof. Sanjay Basu

Project Work undertaken at: Union Bank Of India

Report submitted in partial fulfilment of the requirements for the

award of

Post Graduate Diploma in Management (Banking & Financial Services)

2016-18

By
National Institute of Bank Management, Pune

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 ACKNOWLEDGEMENT
On the completion of this project, I would like to express my humble gratitude to all the people who
have been directly or indirectly involved in it.
To begin with, I would like to thank the Union bank of India ( Treasury)for providing me an opportunity
for interning in their bank. I also want to thank Mr. Pranab Kumar Saha , General Manager, and Mr.
Omprakash Karwa, DGM for giving me the opportunity to work and learn in Treasury Department,
Union Bank of India. I extend my sincere thanks to my executive guide Mr.U V Rajani Kantha Rao , AGM,
Treasury branch for enabling me to work on the subject that is very relevant to the banking sector. He
helped me in every aspect he could.
I want to extent my gratitude to Mr. Mukul Srivastava, AGM, Risk Management Department for giving
me insights into the topic, guiding me throughout, explaining the structural flow and giving necessary
advices as required.
I am immensely grateful to Mr. Darshan Abbad, Chief Manager, Risk Management Departmentwho
took his time away from his busy schedule to help with my queries at every step.
I am grateful to Mr. D Prince, Chief Manager ,Back office ,Treasury Branch for his valuable guidance and
for resolving my queries and for help and support in collecting the data and giving valuable information
for my project.
I also want to thank Mr. Manoj Rathi,Manager, RMD for explaining to me how the risk management
functions.
Thanks are also due to all staff at the bank that provided me valuable insights and added value to my
project.
I am extremely thankful to Prof. Sanjay Basu and Prof K D Mukherjee . I would like to thank again and
express my sincere gratitude to my guide and mentor at NIBM, Prof Sanjay Basufor guiding me
throughout the project.
Last, but not the least I would like thank NIBM for enabling me a practical exposure into the field of
banking through the Summer Internship programme.

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 Executive Summary
Banks bond portfolio comprises of two types of securities SLR securities and NON-SLR
securities. The bank has to maintain for compliance purposes a certain percentage of NDTL as
SLR securities. Banks invests more than 80% of the bond portfolio in SLR securities and the rest
consist of NON-SLR securities, Equities and other instruments. The returns earned by the bank
on these securities constitute a major part of the earning of the bank. And any change in the
value of these securities impacts the profitability of the bank.
These securities are called as Fixed Income securities where the issuer of the bond agrees to
pay a fixed amount of interest on a regular schedule until the maturity date of the bond and at
maturity the principal. These securities have three important components coupon, price and
yield. As we are aware that the price and yield are inversely related and any change in yield
impacts banks income as when the yield increases the prices decrease and the banks suffer
MTM losses and when the yield decreases the prices increase and the bank earns MTM gains.
Bond yields are impacted by the movement in interest rates due to changes in the monetary
policy stance by the Reserve Bank Of India and By the government policy decisions. Since
changes in bond yields severely impacts the profitability of banks. Therefore it is very important
to measure this interest rate risk.
To measure the risk associated with changes in interest rates. We do the pricing and valuation
of the securities present in the bond portfolio and then measure the interest rate risk by
calculating the duration, m-duration and pv01 of the securities and we also calculate duration
and m-duration for the whole bond portfolio to assess the portfolio duration .Duration of a
bond is an estimate of the sensitivity of its price to a change in interest rates, also referred to as
interest rate duration
After calculating the duration, m-duration and pv01 we do the sensitivity analysis using the
stress testing guidelines and applying rate shocks under the Parallel , Steepening and Flattening
shift in the yield curve. Through this we come to know that if the rate shocks move in similar
fashion how much will be the MTM losses/gains of the bank.
Risk associated with changes in interest rates can be managed by using Natural hedging if
available or Derivatives like Forward rate agreements, future contracts, Exchange traded
options contract, interest rate swaps and interest rate futures.
Strategies to increase returns on fixed income portfolio under the current rate environment of
rising rates is investing more in corporate bonds due to high returns and since the yields are on
the rising bias therefore using a low duration strategy would help on account of low price
volatility and accrual income generation.

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Sl.no. Contents Page no.
1 Introduction 5
2 Determination of interest rates and factors 7
affecting it.
3 SLR & NON-SLR securities 9
4 Bond Portfolio Risks 11
5 Methodology 12
6 Analysis and Interpretation 16
7 Sensitivity analysis 19
8 How to manage interest rate risk 25
9 Strategies to insulate a portfolio From rising 27
rates
10 Outlook 29
11 References 30

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Introduction
To understand about the different type instruments in which the banks treasury
invests. The domestic treasury operations include:-

1. The Money Market Operations

2. The Debt Market Operations
3. The Capital Market Operations
.
To understand the working of the treasury and how day to day operations are carried
out. Since treasury is one of the most important departments of the bank being main
profit centre and one of the main function of the treasury department is to control and
manage the bank's money (in terms of capital and liquidity). Treasury ensures that all
parts of the bank has adequate liquidity to carry on there day to day activities.
A treasury department is also responsible for liaising with the bodies that regulate
banks, which set rules regarding banks' capital and liquidity. In order to ensure that
banks are better able to withstand any future market stresses, their capital and liquidity
requirements have become an area of increasing focus.
Understand the risk associated as banks managements are highly sensitive to Treasury
risks, as they arise out of the high leverage of the Treasury business. The risk of losing
capital is much higher than, say, in the credit business.

The changes in macroeconomic condition, government policy decisions and monetary

policy stance of the central bank affects the return that banks earn on investing in
various instruments available in Market.
(a)Government policy decisions

For eg. As on November 11 ,2016 Indian banks held around Rs. 29 lakh crore of government
bonds. Demonetisation as announced by the govt. on 8 November,2016 led to surge in deposits
with the Indian banks and the demand government and high rated corporate bonds increased.
With the increase in demand bonds created a downward pressure on the yields.
As yield and price are inversely related i.e. if yield on a bond rises the prices come down and if
the yield on the bond falls the price increases. The banks which have invested in bonds when
the yields were high and prices low if compared with situation when the bond yields dropped
and the prices started to rise mainly due to excess liquidity with banks due to demonetization.
This enabled banks to book MTM gains.
The banks, which were facing weak profitability, pressure on asset quality and weakness in
lending business, to strengthen their capital adequacy ratios, besides providing a likely

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opportunity for better-placed banks to improve their provision coverage ratios (money set
aside to cover bad loans), which until recently was witnessing a downtrend.

(b)Monetary policy changes by Central bank

Monetary policy changes by the central banks affects banks returns. For eg. When interest rates
rise, the market value of bonds decreases that means the net asset value (NAV) of the Mutual
fund having more of Bond portfolio decreases. Central Bankers are more interested in
controlling the inflation in the Economy and thus reduce the liquidity in the economy. Due to
reduced liquidity and costly credit the bond prices declines and the bond yields rises and the
opposite happens when the interest rates are lowered. The impact is mainly on the securities
which are classified in AFS (available for sale) and HFT (held for trading) and not on securities
which are classified as HTM (held till maturity).

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Interest rates
An interest rate is the cost of borrowing money. Or, on the other side of the coin, it is the
compensation for the service and risk of lending money. Without it, people would not be willing
to lend or even save their cash, both of which require deferring the opportunity to spend in the
present. But prevailing interest rates are always changing, and different types of loans offer
various interest rates.
Lenders and Borrowers
The money lender takes a risk that the borrower may not pay back the loan. Thus, interest
provides a certain compensation for bearing risk. Coupled with the risk of default is the risk
of inflation. When the lender lends money, the prices of goods and services may go up by the
time money is paid back, therefore original purchasing power of money would decrease. Thus,
interest protects against future rises in inflation. A lender such as a bank uses the interest to
process account costs as well.

Borrowers pay interest because they must pay a price for gaining the ability to spend now,
instead of having to wait years to save up enough money. For example, a person or family
may take out a mortgage for a house for which they cannot presently pay in full, but the loan
allows them to become homeowners now instead of far into the future.

Businesses also borrow for future profit. They may borrow now to buy equipment so they can
begin earning those revenues today. Banks borrow to increase their activities, whether lending
or investing and pay interest to clients for this service.

Determination of interest rates and the factors affecting interest

rates.
Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the
demand for credit will raise interest rates, while a decrease in the demand for credit will
decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a
decrease in the supply of credit will increase them .The supply of credit is increased by an
increase in the amount of money made available to borrowers. For example, when a bank
account is opened, one is actually lending money to the bank. Depending on the kind of
account is opened (a certificate of deposit will render a higher interest rate than a checking
account, with which one has the ability to access the funds at any time), the bank can use that
money for its business and investment activities. In other words, the bank can lend out that
money to other customers or the bank can invest that money in securities of the Govt. or a
company . The more banks can lend, the more credit is available to the economy. And as the
supply of credit increases, the price of borrowing (interest) decreases.

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 Inflation
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest
rates are likely to rise. This occurs because lenders will demand higher interest rates as
compensation for the decrease in purchasing power of the money they will be repaid in the
future.
Government

The Government has a say in how interest rates are affected. The Government often makes
announcements about how monetary policy will affect interest rates. The repo rate , or the
rate that institutions charge each other for extremely short-term loans, affects the interest
rate that banks set on the money they lend; the rate then eventually trickles down into other
short-term lending rates. The central bank influences these rates with open market operation
which is basically the buying or selling of previously issued Govt. securities. When the
government buys more securities, banks are injected with more money than they can use for
lending, and the interest rates decrease. When the government sells securities, money from
the banks is drained for the transaction, rendering fewer funds at the banks' disposal for
lending, forcing a rise in interest rates.
Types of Loans
Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces
behind interest rate levels. The interest rate for each different type of loan, however, depends
on the credit risk, time, and convertibility of the particular loan.

(a). Risk refers to the likelihood of the loan being repaid. If the risk involved is less then the
interest rate is likely to be lower and vice-versa. For eg. government-issued debt securities carry
very little default risk as there is very little risk because the borrower is the government. For
this reason, the rate on treasury securities tends to be relatively low.

(b).Time is also a factor of risk. Long-term loans have a greater chance of not being repaid
because there is more time for adversity that leads to default. Also, the face value of a long-
term loan, compared to that of a short-term loan, is more vulnerable to the effects of inflation.
Therefore, the longer the borrower has to repay the loan, the more interest the lender should
receive.

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SLR and NON-SLR Securities
The banks bond portfolio is divided under three heads HTM, HFT, and AFS. A held-to-
maturity security is purchased with the intention of holding the investment to maturity. A held-
for-trading security refers to debt and equity investments that are purchased with the intent of
selling them within a short period of time, usually less than one year. Available for sale, or AFS,
is the catch-all category that falls in the middle. It is inclusive of securities, both debt and
equity, the company plans on holding for a long period of time but could also be sold.
The banks bond portfolio is divided in SLR and NON-SLR securities and then the securities are
placed in the HFT, HTM, AFS accordingly.
Banks treasury profits depends on the return that the bank gets when they invest in SLR and
NON-SLR securities. SLR are securities were the bank invest mainly for compliance purposes as
the bank has to maintain some percentage of their net demand and time liabilities in SLR.
Investment decisions are made in SLR securities without seeing the return on investment. As
the regulator the Reserve bank of India ask banks to maintain it.
Investment made in Non-SLR securities are to earn high returns. These securities offer good
return to banks. Banks invest in those securities by seeing the coupon rate and the yield on
investment that the bank earns by investing in these securities. Banks also see the credit rating
of these securities before investing in those securities. The securities must be of investment
grade.
These securities are termed as Fixed income securities as the issuer of the bond agrees to pay a
fixed amount of interest on a regular schedule until the maturity date of the bond. At the
maturity date, the borrower returns the principal amount to the investor. The fixed amount of
interest is known as the coupon rate, whereas the principal amount of the bond is known as the
par or face value. There are a number of different type of fixed income securities, including G-
secs, corporate bonds, high yield bonds and tax-free municipal bonds.
The main factors that impact the prices of fixed income securities include:-
Interest rate changes .
(i) The main risk that can impact the price of bonds is a change in the prevailing interest
rate. The price of a bond and interest rates are inversely related. As interest rates rise,
the price of bonds falls, since investors can obtain bonds with a superior interest rate,
which decreases the value of a bond that has already been issued. On the flip side,
current bond holders are benefited by a drop in interest rates, which makes their bonds
more valuable; other investors seek out higher yields of previously issued bonds. Bonds
with longer maturities are subject to greater price movement upon interest rate
changes, since an interest rate change has a larger impact on the future value of the
coupon.

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Default or Credit risk
(ii) The second main factor is credit or default risk. There is a risk of default if the issuer will
go out of business and be unable to pay its interest rate and principal obligations.
Issuers of high-yield bonds have more credit risk, since there is likely a greater risk of
default. To compensate investors for this higher risk, such bonds often pay higher
interest rates. Credit rating agencies provide credit ratings for the issuers of bonds and
can help investors gauge the risk associated with certain corporate bonds.
Secondary market liquidity risk
(iii) Except for government debt, most bonds are traded over the counter (OTC) and
therefore carry a liquidity risk. Unlike the stock market, where investors can easily exit a
position, bond investors rely on the secondary market to trade bonds. Investors who
need to exit a bond position to access their invested principal may have a limited
secondary market to sell the bond. Further, due to the thinner market for bonds, it can
be difficult to get current pricing. Bonds vary so much in their maturities, yields and the
credit rating of the issuer that centralized trading is difficult

Interest Rate Risk

(iv) Interest rate risk affects the value of bonds more directly than stocks, and it is a major
risk to all bondholders. As interest rates rise, bond prices fall, and vice versa. The
rationale is that as interest rates increase, the opportunity cost of holding a bond
decreases, since investors are able to realize greater yields by switching to other
investments that reflect the higher interest rate. For example, a 5% bond is worth more
if interest rates decrease, since the bondholder receives a fixed rate of return relative
to the market, which is offering a lower rate of return as a result of the decrease in
rates.
When and why the interest rates fall-

The current era of extraordinarily low interest rates is best explained by the unprecedented actions by
the Fed and other central banks in response to the financial crisis. We saw how the Fed initially
employed traditional monetary policy tools, lowering the federal funds target rate from 5.25% in
September 2007 to a 0%-to-0.25% range in December 2008 (where it has remained since). Then, in
November 2008, amid near-frozen credit markets, overnight rates close to zero and the US economy
mired in the worst recession since the 1930s, the Fed embarked on a programme of quantitative easing
(QE). The central bank extended the size and average maturity of their balance sheet assets through the
purchase of Agency debentures, Mortgage Backed Securities (MBS) and Treasuries. These actions sought
to contain the financial crisis, limit its impact on the broader economy, and aid the prolonged recovery
by lowering longer-term interest rates to encourage investment and consumption.

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Bond portfolio risks
Strategies for enhancing bond portfolio returns can be best understood in the light of the risks
to which bond portfolio are subject. All the bond portfolios are subject to three types of basic
risks:-
1. Quality may decrease because of adverse changes in the business or economic
conditions of the bond issuers.
2. The portfolios optimum average maturity may be modified as a result of changes in the
shape of the yield curve.
3. Interest rates may fail to rise as rapidly as the inflation rate, resulting in negative real
return.
Recently the bond portfolio returns have been affected by two particular forms of interest
rates risks:-
The risk that interest rates may decline, so that reinvestment of portfolio income will
be made at ever lower rates of return and the original desired yield to maturity will
not be realized.
The risk that interest rates may rise resulting in a drop in the market value of the
entire portfolio the cannot be offset by increasing returns on reinvested interest.
Indeed this second risk has truly devastated some bond portfolios. Bond portfolios are
traditionally designed to minimize business risk, however todays managers adopt strategies to
enhance portfolio returns under conditions of rapidly changing interest rates or face
unacceptable results.

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Methodology
Using the sample SLR portfolio given by the bank. The securities in the bond portfolio was
divided into HTM, HFT and AFS category. Only HFT and AFS securities are used in our
analysis. The bond pricing and valuation was done using the data given in the bond portfolio.
After doing the pricing and valuation of the securities in the portfolio. The duration and m-
duration was calculated and then PV01 was also computed and after that Portfolio duration and
Portfolio PV01 was computed to measure the overall sensitivity of the bond prices to changes in
interest rates. The portfolio was divided into four buckets according to the residual maturities i.e.
less than one year, one to three year, three to five year and then above five years. Sensitivity
analysis was done using the Stress Testing guidelines by applying the rate shocks and calculating
the MTM losses/gains.
Bond Returns
There are two primary components of a bonds total return for a given period: interest income
and change in price. Interest income return is driven by the coupon the bond pays or accrues
over the period, while price return is based on the change in market price. A bonds market
price fluctuates due to changes in the yield demanded by investors as well as any accretion (or
amortization) of bonds that trade at a discount (or premium), which is due to the pull to par
effect. Both of these factors will be discussed in more detail in the following sections.

Bond valuation
A bonds price is equal to the present value of its future cash flows discounted at a given
interest rate or set of rates. As the required yields demanded by investors increase (or
decrease), the discount factor(s) applied to those cash flows increase (or decrease) and the
present value, or price, of the bond falls (or rises). This explains the inverse relationship
between interest rate movements and the change in prices on existing fixed coupon bonds.
While this full valuation approach should result in the most accurate estimation of the change
in a bonds price when rates move, it can be time and resource consuming. A simpler
estimation of the change in value of a fixed coupon bond given a small change in interest rates
can be made using the bonds duration
A bonds price is the sum of the present value of its future cash flows:-

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Duration
Generally speaking, the duration of a bond is an estimate of the sensitivity of its price to a
change in interest rates, also referred to as interest rate duration. The larger (i.e., longer) the
duration, which is stated in years, the more sensitive a bonds price is. For example, if a fixed
coupon bonds duration is two years and interest rates increase by 50 bps (0.50%), the duration
would estimate an approximate 1% drop in its price (2 x 0.005). Assuming it was initially priced
at par ($100), then the new price would be approximately $99. For a bond with a five-year
duration, the expected price decrease would be approximately -2.5%, to $97.50. The duration
of a portfolio of bonds is the market-weighted average of the duration of all the holdings in that
portfolio. One of the drawbacks to using duration is that it is a linear estimate, when in actuality
a bonds price moves in a convex fashion as yields change (Exhibit A2). One way to improve the
accuracy of the estimate is to use a convexity adjustment.6 However, to simplify our discussion,
throughout this paper duration is used when discussing estimated price impacts.

Duration will estimate the change in price most accurately for a small change in yields, as seen
by the closeness of fit of the straight line immediately to the left and right of the starting point
(small square). As rates move further from the starting point, the duration estimate of price is
less accurate (i.e., the straight line moves farther away from the sloped curve). A convexity
adjustment improves the estimate, reducing the distance between the straight line and sloped
curve.
Spread duration
Spread duration is a similar concept to that of interest rate duration. Bonds whose issuers are
not considered risk-free will typically have higher yields than the risk-free rate.7 The difference
in yields represents the credit spread and compensates the bond buyer for assuming increased
credit risk (which is the risk of not receiving the scheduled interest and principal payments).
Spread duration estimates the price sensitivity of a bond to a change in the spread incorporated
into that bonds yield. If spreads widen to reflect the markets requirement for more
compensation for greater credit risk, then the bonds yield could increase and cause its price to

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decline. If market perception of credit risk declines, then credit spreads tighten and prices
increase, assuming underlying risk-free rates remain unchanged. It is important to note that
interest rates and credit spreads can move independently or in conjunction with each other.
The movement of either can have a significant impact on the price return of a bond with credit
risk.
For example, consider the U.S. Treasury note with a 2% coupon maturing on February 15, 2023.
It was auctioned as a new 10-year Treasury on February 13, 2013. If purchased at a par dollar
price ($100), the security should yield 2% if held to maturity. However, rates have since risen,
causing this bonds yield to increase to approximately 2.73% on August 15, or its price to fall to
$93.95. As expected, rates rose and the price fell (Exhibit A3).
Assuming the U.S. government will pay back its debts, the bond will pay back the $100 par
value at maturity. This change in price from its current discount to the eventual value of par at
maturity is known as the pull to par effect. Note that this will take considerable time if rates
stay at or above 2.73% given the 10-year tenor of the security. If the yield required by the
market for buying this U.S. Treasury does not retrace to 2%, the owner who bought at par will
be carrying the bond at an unrealized loss until maturity. If the investor needs to raise cash and
chooses to sell this security, then that loss will become realized.

Extension risk
It is important to note that some types of securities, such as mortgage-backed securities or
callable bonds, allow the borrower the option to pay down principal earlier than originally
scheduled. During periods when interest rates fall, borrowers eager to refinance or issue debt
at the new lower rates will typically pay back their principal at a faster pace. Consider the
example of homeowners who refinance their mortgages when rates fall. As this prepayment
takes place, MBS pass-through securities that include a number of refinanced mortgages will
generally see a return of principal sooner than originally anticipated. When rates rise, the
opposite usually occurs as principal payments slow and durations of these instruments extend.

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This is known as extension risk. In these instances, the duration of a portfolio that owns these
securities will also increase (or lengthen), exposing it to greater interest rate sensitivity going
forward. The longer duration will also increase the opportunity cost to the portfolio by delaying
the return of principal, resulting in a reduced ability to take advantage of higher rates. Duration
extension can be hedged via sales of these or other securities in the portfolio. Such sales of cash
securities (non-derivatives) often result in realizing losses or making permanent those
temporary decreases in bond prices due to the higher rate environment into which they are
sold.
Portfolio Duration
Duration is an effective analytic tool for the portfolio management of fixed-income securities
because it provides an average maturity for the portfolio, which, in turn, provides a measure of
interest rate risk to the portfolio. The duration for a bond portfolio is equal to the weighted
average of the duration for each type of bond in the portfolio:
Portfolio Duration = w1D1 + w2D2 + + wKDK
wi = market value of bond i / market value of portfolio
Di = duration of bond i
K = number of bonds in portfolio
To better measure the interest rate exposure of a portfolio, it is better to measure the
contribution of the issue or sector duration to the portfolio duration rather than just measuring
the market value of that issue or sector to the value of the portfolio:
Portfolio Duration Contribution = Weight of Issue in Portfolio Duration of Issue

Modified duration is a measurement of the tangent to (or slope of) the price-yield curve for the
prevailing rate of interest. Because the relationship between price and yield is not linear,
modified duration as a measurement of the sensitivity of the bond price to a yield change is
only accurate for very small changes in yield.

Benefits of the use of duration to manage interest rate risk

Despite the above criticisms, the concepts of duration and convexity are both very useful to the
interest rate risk manager. As we have shown, both concepts are relatively straightforward to
understand and values can be calculated easily. Whilst it is true that both measurements are
inexact, they do provide the interest rate risk manager with an overall picture of the exposure
to a change in interest rates, particularly in the short term. In addition, the fact that the
duration and the convexity for a number of instruments can be combined into one value means
that the interest rate risk manager can develop an approximate view of the exposure of a whole
portfolio very quickly. Indeed, it is also worth remembering that the nature of interest rate risk
is uncertain and it will never be possible to completely eliminate any exposure. For that reason,
any attempt to assess an exposure could be seen as misleading.

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Analysis and Interpretation
Relationship between Bond Yields and Repo Rates
10

Gsec repo rate

A cut in the repo rate lowers banks' borrowing costs. This makes them cut both lending and
fixed deposit rates. Falling rates across the debt markets increase the demand for instruments
that pay higher interest. At this stage, prices of bonds which banks had bought when interest
rates were high rise, as there is a scramble among investors to lap up these higher-yielding
securities.

Hence, the value of government securities that banks have bought for the SLR requirement
rises. This increases profits as banks record the market value of these securities in their books.
Under this process, called marking to market, organisations record profits/losses in their books
on a daily basis without actually booking any profit or loss. So, more SLR bonds the bank holds,
the higher its mark-to-market profit. The opposite happens when there is a rise in rates.

From the above graph we can see that the monetary policy stance adopted by the Reserve Bank
of India affects the Movement in bond yields. As the correlation of 0.8805 between the two
suggest that there is a strong positive correlation i.e. when there is a cut in repo rates the bond
yields also falls and when there is rise in repo rates bond yields rises. Therefore this indicates
that RBIs policy rates decisions affects the bond yields, consequently affecting banks profits.
This will be further explained in the next graph.

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Relationship between Gsec yield and trading gains

10 3500
9
3000
8
7 2500
6 2000
5
4 1500

3 1000
2
500
1
0 0

TRADING GAINS(crs) Gsec

Combined trading gains of five large public sector banks is shown in the above graph. The data
is between Q4-FY14 to Q3-FY16.By analyzing the above graph we assess that when the bond
yield rises then there is a dip in the trading gains and when bond yield falls then the trading
gains increase. The correlation of -0.8898 between the Gsec-yield and Trading gains suggest
that there is a strong negative relationship between the two. Also from the graph we can see
that the Gsec yields has dipped over the period and the Trading gains have risen over the
period.
With falling bond yields, the Available-for-Sale (AFS) book of public-sector banks has seen quite
a good run over the past few months. Banks are now making hefty treasury gains from the rise
in the bond prices. Falling yields gives the banks the option to liquidate some securities and
book profits.Such profit results in treasury gains. If a bank's earnings are hit due to higher
provisions for bad loans, this one-off profit may cushion the profit margin.

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 Movement of G-sec yields
10
9
8
7
6
5
4
3
2
1
0

From the graph we can see that the bonds yields have dropped considerably over the past 2 to
3 years. The bond yields were hovering around 8.25% in the quarter ended Q1-FY13 but we can
see that the bond yields have dropped to 6.694% in the Q4-FY17 This is due to the
accommodative stance adopted and the rate cut done by the Reserve bank of India in the last 2
to 3 years. Presently due the government policy of Demonetisation announced in 08,
November 2016, lead to surge in deposits with the banks and subsequently leading to increase
demand for government and high-rated corporate bonds, it caused downward pressure on
yields given the current tepid credit-demand scenario. Banks which hold about R29 lakh crores
of government bonds (as on November 11, 2016) are poised to benefit from the softening of
yields.
This development enabled banks, which were facing weak profitability, pressure on asset
quality and weakness in lending business, to strengthen their capital adequacy ratios, besides
providing a likely opportunity for better-placed banks to improve their provision coverage ratios
(money set aside to cover bad loans), which until recently was witnessing a downtrend.
The gains also enable public sector banks to contribute towards their Basel-III capital
requirements reducing the need to raise capital from outside.
But as we have seen that the RBI has change its stance from accommodative to neutral there
may be threat to the Banks .As we have seen that the bonds yields have risen in the quarter
ended 2017 .Due to the neutral stance adopted by the RBI the bond yields may be on the rising
bias in coming months of 2017. And what we saw in the bi-monthly policy statement of RBI
where everybody has expected that the RBI will cut the policy rates but it did the reverse .RBI
did not cut the policy rates it caused havoc in the market. Since then the bond yields have been
on the rising bias. The main reason behind the fear of rising rates is that the rise of bond yields
causes erosion in banks treasury profits.

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A drop in bond prices hurts the banks as they need to mark to market (MTM) or value a
substantial portion of their bond portfolio in accordance with the market price and not the
prices at which they were bought historically. Even though the banks in India need to have a
mandatory investment of 20.5% of their deposits in government bonds, many banks,
particularly the state-run ones, hold more; the average bond holding in the industry could be
around 26%. The mandated holding of 20.5% can be kept in the so-called held to maturity, or
HTM segment, which does not need to be marked to market; but the rest of the portfolio can
be kept in a combination of the so-called available for sale (AFS) and held for trading (HFT)
baskets, and it needs to be valued in accordance with the prevailing market price, or marked to
market. Foreign banks too are subject to the same regulations but typically, they mark to
market their entire bond portfolio

Sensitivity Analysis
Sensitivity analysis estimates the impact on a banks financial position due to predefined
movements in a single risk factor like interest rate, foreign exchange rate or equity prices, shift
in probabilities of defaults (PDs), etc. In the sensitivity analysis generally, the source of the
shock on risk factors is not identified and usually, the underlying relationship between different
risk factors or correlation is not considered or ignored. For example, the impact of adverse
movement in interest rate or foreign exchange rate on profitability is considered separately but
the fact that movement in interest rate and foreign exchange rate is inter-related is ignored to
keep stress test simple. These tests can be run relatively quickly and form an approximation of
the impact on the bank of a move in a risk driver.
Banks should then stress the identified risk drivers using different degrees of severity. In our
analysis, a sensitivity test is conducted to explore the impact of varying fall in Bond prices due
to a range of increases in interest rates such as by 100, 200, 300 basis points.
Bank invest in Govt. bonds and Corporate bond, the Govt. securities are referred as SLR
securities and the Corporate bonds are referred as NON-SLR. The bank has to maintain some
percentage of their NDTL-Net demand and time liabilities in SLR securities for compliance
purposes. The return that the bank earn on SLR Securities is less compared to the return that
the bank earn when they invest in Non- SLR securities. The return on Govt. securities is less if
compared to Non-SLR securities because these govt. securities are Risk-free securities i.e. they
are fully backed by the government. More than 80 % of the bond portfolio of bank comprise of
SLR securities. Therefore any movement in interest rates affects the value of the bond portfolio.
Subsequently affecting the income of banks.
The sample portfolio used in the analysis consist of SLR securities comprising of both Central
government and State government securities of varying maturities. Using the data given in the
sample portfolio. After computing these results the portfolio of the bank was divided in
different buckets according to their residual maturities .After that the market value of a bond

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was computed. Subsequently the Duration ,Mduration, weighted duration and portfolio
duration was computed .Portfolio duration and Mduration of the banks is computed.
SLR Protfolio on the basis of Residual Maturity(in crs)

0-12 m 12-36 m 36-60 m over 60 m Total

13,995.5
Market value of securities(in crs) 1,064.00 3707.96 2485.82 6737.74 2
Duration 0.53 1.79 3.56 5.32
M-Duration 0.51 1.74 3.44 5.14
PV01 of the entire exposure(in 545,048.3 6435363.5 34622287.7
Rs) 8 8 8,560,409.21 6
Weighted average yield(%) 6.50 6.63 6.98 6.91

The bank portfolio has around 7.6% exposure to less than one year ,26.5% exposure to 1 to 3
year, 17.8% exposure to 3 to 5 year and 48.1% exposure to more than 5 year securities. This
indicates that the bank invests mostly in longer tenor securities above 5 years. This is due to the
fact that return generated on longer term securities higher compared to investment in shorter
term securities. From the above chart we can see that Duration of the more than 5 year bucket
is more than the duration of shorter term buckets . From this we can interpret that the bucket
containing more than 5 year securities have the highest interest rate sensitivity.
If the longer term interest rates change the bank will be most affected . Firstly due to high
duration and secondly as this bucket has the highest weight.
From the PV01 of the different buckets we can interpret that if there is a one basis point change
in yield there will be MTM loss in rupees. Since both the duration and the weight of above 5
year bucket is the highest any change in the bond yield will impact this particular bucket most.
As we can see this from the PV01 of different buckets Less than 1 year-Rs.5,45,048.38, 1 to 3
year- Rs. 64,35,363.58, 3 to 5 year- Rs. 85,60,409.21, above 5 year Rs.3,46,22,287.76.

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Using the Sensitivity Analysis

In this report, a sensitivity analysis is done by looking at the G-sec yield curve, using tenors in
less than 1, 1 to 3 years, 3 to 5 years, above 5 years. We then shock, or change, the yield at
each point along the curve, resulting in a hypothetical yield curve . Using this hypothetical shift
in the curve, we estimate the approximate loss to the if the yield moves by a particular basis
point.

Parallel shift in the Yield curve

Starting
Maturity rate shock(%) new rates(%)
rates(%)

0-12 m 6.5 0.50 7.00

12-36 m 6.63 0.50 7.13
36-60 m 6.98 0.50 7.48
over 60 m 6.91 0.50 7.41

Parallel shift in yield curve

7.6
7.4
7.2
7
6.8
6.6
6.4
6.2
6
0-12 m 12-36 m 36-60 m over 60 m

Starting rates(%) new rates(%)

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A shift in economic conditions in which the change in the interest rate on all maturities is the
same number of basis points.A parallel shift in the yield curve is a when the interest rates on all
- short-term, intermediate, and long-term buckets, increases or decreases by the same number
of basis points. For example, if 1-year, 5-year, 8-year, 10-year, 15-year, 20-year, and 30-year
bonds all increased by 1.50%, or 150 basis points, over their previous level, this would be a
parallel shift in the yield curve because the curve itself didn't change, rather all data points on
it moved to the right of the graph while maintaining its prior slope and shape. Therefore in our
report the rates are increased across different buckets uniformly by 50 basis point. The yield
curve shifts above by 50 bps.When the rate shocks of 50 basis point is applied uniformly across
the buckets. The overall portfolio value which is Rs.13,995.52crs decrease by Rs.250.81. the
rate shock is only 50 basis points but change is significant it is due to higher weight in longer
term maturities.
But in reality in is uncommon that a parallel shift would happen. Yields of different maturity
rarely moves uniformly.

(v) Steepening of the yield curve

Starting
Maturity rate shock(%) new rates(%)
rates(%)

0-12 m 6.5 0.60 7.10

12-36 m 6.63 0.90 7.53
36-60 m 6.98 1.20 8.18
over 60 m 6.91 1.60 8.51

Steepening of the yield curve

9
8
7
6
5
4
3
2
1
0
0-12 m 12-36 m 36-60 m over 60 m

Starting rates(%) new rates(%)

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When the yield curve steepens, the gap between the yields on short-term bonds and long-term
bonds increases, making the curve appear "steeper." The increase in this gap indicates that
yields on long-term bonds are rising faster than yields on short-term bonds or, occasionally,
that short-term bond yields are falling even as longer-term yields are rising. A steepening yield
curve typically indicates investor expectations for 1) rising inflation and 2) stronger economic
growth. Therefore the rate shocks that are applied on the portfolio are as follows less than one
year 60 bps, 1 to 3 year 80 bps , 3 to 5 year 100 bps and above 5 year 160bps.

In our first scenario the assumed a parallel shift up in rates, but yield curves rarely move in a
parallel fashion. Therefore we would expect the curve to steepen as the market begins to price
in a reduction in the pace of bond purchases by the RBI, causing the intermediate and longer
part of the yield curve to rise faster than the very front end. When this occurs, negative returns
on bonds with longer durations are magnified.

The second scenario for the same hypothetical six-month period depicts such a situation, in
which the shift in rates is more pronounced for longer maturity bonds than for shorter ones,
with the change in the one-year and above 5 year security now +60 bps and +160 bps,
respectively. As expected, the negative impact on total return is greater for longer securities

After applying the rate shocks if the interest rates increase in this fashion the bank will face an
MTM loss of Rs. 717.87 crs.

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 Flattening of yield curve

Starting
Maturity rate shock(%) new rates(%)
rates(%)

0-12 m 6.5 3.32 9.82

12-36 m 6.63 1.72 8.35
36-60 m 6.98 0.33 7.31
over 60 m 6.91 -1.32 5.59

Flattening of yield curve

12

10

0
0-12 m 12-36 m 36-60 m over 60 m

Starting rates(%) new rates(%)

When the difference between yields on short-term bonds and yields on long-term bonds
decreases, the yield curve flattens, that is, it appears less steep. A flattening yield curve can
indicate that expectations for future inflation are falling. Since inflation reduces the future
value of an investment, investors demand higher long-term rates to make up for the lost value.
When inflation is less of a concern, this premium shrinks. A flattening of the yield curve can also
occur in anticipation of slower economic growth.
According to current economic scenario and the change in monetary policy stance of RBI to
neutral from accommodative and RBIs continued thrust on maintaining CPI inflation at lower
levels, interest rate seems to have bottomed out in current cycle. Further, best of the easy
banking system liquiditydriven by ban on Specified Bank Notes (SBNs) , with majority of
currency making its way back into the economy. Bond yields are expected to be stable or have
an upward bias as the Indian economy remonetizes. CPI inflation is expected to move up due to
the implementation of 7th Pay Commission allowance, increase in minimum support prices and
upward pressure from global commodity prices. However, FII flows and insurance demand is
expected to be strong which should support bond yields.

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 How to manage Interest rate Risk
Monitoring interest rates and acting on changes in them is an important part of a treasurers
role. Whether looking at the yield on excess cash invested or the interest rate on outstanding or
new issue debt, treasurers need to be aware of the impact of interest rate changes on the
balance sheet, P&L and the instruments and techniques available to mitigate the effects of
those changes.
Companies with floating or variable rate debt outstanding are exposed to increases in interest
rates, whereas companies with borrowing costs which are totally or partly fixed will be exposed
to falls in interest rates. The reverse is true for companies with cash term deposits.
It involves a decision to accept exposure either to a fixed interest rate or a floating rate. This
decision can be taken at any time over the life of a debt or an investment and can be modified
at any time. It is also possible to purchase instruments that cap interest rates at a maximum,
floor them at a minimum or allow them to fluctuate within a pre-defined band. Deciding to fix,
float or accept a defined range of possible interest rates is the definition of managing interest
rate risk. Hedging a floating interest rate means deciding to fix all or part of the exposure.
Hedging a fixed rate exposure means deciding to transform all or part of it into floating rate.
The following table lists the main instruments used for this:

Tool Description Comment

In normal times, for example, construction firms

Creating interest rate exposures that are enjoy a rise in business activity when interest
Natural offset by elements of the companys rates fall, as investors build more when the cost
hedging natural business cycle. of projects is lower.

Forward A 3v6 FRA allows a firm to fix the three-month

rate An FRA is a tool for fixing future interest Libor (or other reference) rate in three months
agreement rates (or unfixing them) over shorter time. It is dealt over the counter (with banks)
(FRA) periods, up to say one to two years. and can be tailored to any (short-term) tenor.

Futures are exchange-traded, have fixed tenors,

terms and conditions, and require complex
Futures margining. They are therefore less flexible than
contracts Futures have the same function as FRAs. over-the-counter instruments.

Exchange- Interest rate options, bond options and

traded options on fixed-income exchange Exchange-traded options have the same
options traded funds are short-term instruments drawbacks as exchange-traded interest rate

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Tool Description
contracts used to express views on whether rates
will rise or fall.
An option that caps the interest rate
payable by a borrower over its life.
Below the cap level, the interest rate
Cap payable is floating.
An option that fixes the minimum
Floor interest rate receivable over its life.
A collar combines the purchase of a cap
and a floor. This sets a corridor of
possible interest rates between a
Collar maximum and a minimum.
An interest rate swap changes the nature
Interest of a stream of interest payments from
rate swap floating to fixed or vice versa.
A swaption is an instrument where the
buyer of a swaption has the right to
enter into an interest rate swap as either
payer or receiver of the fixed rate at a
particular rate, thus protecting the buyer
against adverse movements in long-term
rates, while allowing him to benefit from
Swaption favourable moves.
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Comment
futures contracts.
Caps are dealt over the counter by banks. The
commonest use is by borrowers who need to
avoid covenant breaches that would be caused
by sharp rises in rates and so purchase a cap to
set the maximum rate they will have to pay over
the life of a bond or loan.
Floors are dealt over the counter by banks.
Treasurers with cash invested might buy a floor
that is lower than current interest rates to set a
minimum return.
A borrower would buy a cap and sell a floor,
usually over the counter, thus creating a collar,
or corridor, of rates. Usually the purchase and
sale prices cancel each other out.
Swaps are dealt over the counter and the
market is large and deep. Maturities of anything
from one year to 30 years are available.
Swaptions are usually only used by non-financial
firms in relation to a specific event such as a
bond issue or an M&A transaction that will
require funding.
Strategies to insulate a portfolio from rising rates
Some investors may choose to simply exit the asset class, there are strong arguments for maintaining a
core allocation to fixed income. In most rate environments, fixed income provides diversification, a
steady stream of income and a lower volatility investment over time. Additionally, fixed income
portfolios with greater duration have historically provided higher returns, albeit with greater volatility,
over longer time horizons. However, for investors with shorter investment horizons (especially those
with potential near term cash needs), or those looking to protect profits from longer duration strategies,
a key priority is to mitigate potential volatility during the anticipated rising rate period. To that end,
investors should consider how they can best deploy two effective strategies for managing a rising rate
environment: shortening duration and increasing income.

(i) Shortening portfolio weighted average duration

The most effective way to protect a portfolio from the impact of rising rates is to reduce its weighted
average duration. In traditional fixed income portfolios, this is typically achieved using one or more of
the following methods:

Sales of longer dated fixed coupon securities, and/or reinvestment of interest income, into
those with shorter tenors.

Investments in higher income or higher yielding securities, which will have shorter interest rate
durations relative to bonds with the same maturity. By investing in credits with spreads over the
risk free rate, more cash is received on the coupon payment dates thereby shortening the
duration and increasing the cash available to be reinvested at higher rates.

Purchases of floating rate notes, whose interest rates reset on a regular basis. As a floaters
interest rate resets to adjust for market changes, its price should typically experience less
volatility and thus it will have a lower duration.

With the latter it is worth pointing out that most floating rate notes reset interest rates on a monthly or
quarterly basis thus durations on these securities are typically shorter than three months. However, it is
important to note that while the owners of such bonds have limited exposure to changes in interest
rates, they are exposed to the creditworthiness of the borrower until the final maturity of the bond. This
means that floating rate bonds, not issued by the US Treasury, can have longer spread durations than
interest rate durations. This can result in greater volatility should credit conditions change.

(ii) Increasing the interest income component of total return

Increased income or yield not only lowers duration but also provides greater income return helping
offset declines in price in periods of rising rates. However, higher yields due to increased credit exposure
do not come without added risk. Should credit spreads widen in conjunction with rising rates, these
securities will underperform. Similar to interest rate duration fixed income investors must be cognizant
of spread duration as well. Longer spread durations will typically be more negatively impacted by
widening credit spreads. Due to the risk of widening credit spreads it is important that an investor
examine where credit spreads are relative to historical patterns at the beginning of a rising rate period.

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 (iii) Optimal strategy
As interest rates rise and the yield curve begins to steepen, accepted wisdom suggests investors should
shorten maturity, and thereby reduce duration (the price sensitivity of a bondlonger duration means
the price fluctuates more as the yield moves up and down). By reducing maturity, the thinking goes,
investors avoid large potential price shocks in their bond portfolio. In today's bond market, with the RBI
intent on keeping short-term interest rates low for the near future, shortening maturity in isolation
results in little income. For investors who depend upon income ,low yields are often times insufficient
to meet expenses. However, with the yield difference between 2-year and 10-year bonds longer tenor
bonds earning more, investors may be rewarded for laddering maturities out to 4-5 years despite the
eventual risk of rising rates.
(iv) Broadening the investment portfolio
Broadening the investment portfolio strategy for bond investors to consider today is broadening
investments to lower rated (a.k.a. "below investment grade") credit sectors. While departing from the
world of investment grade credit may be slightly uncomfortable for some, moving down the "credit
curve" affords investors both potentially improved yield/total return and lower bond price sensitivity to
changes in interest rates (see table below).While a lower credit rating is not necessarily synonymous
with lower quality, such investments typically require thorough company research but we believe that
investors can be rewarded for doing their homework in today's low yield environment. By sifting
through the universe of below investment grade corporate bonds, emerging market bonds, and the like,
investors can find securities that perform relatively well in rising interest rate environments.
Investments in below investment grade securities benefit from improving economic growth and rising
inflation expectations which are two of the conditions that can trigger rising interest rates.
In summary, this strategy is an effective way to better optimize the tradeoff between principal
protection and income generation.
(v) Investing in high dividend paying stocks
Investors in high dividend paying stocks can reap the benefits of relatively stableand possibly
growingdividend payments while potentially enjoying inflation protection and upside price potential.
This is possible because investors are "owners" in the business rather than creditors and share in any
inflation-generated increases in revenues and earnings .High dividend paying stocks offer another
potential benefit.

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Outlook
Surveying the factors that drive interest rates, we see that while the recent period has witnessed a
increase in yields, higher yields also create opportunity. Moderate inflation and steadily recovering
economic growth should gradually nudge Gsec yields moderately higher over the next couple of years.
Obviously, yields on NON-SLR securities would also ratchet up accordingly.
As yields move higher, investors can profit by resisting the temptation to rely exclusively on short-term
Treasuries. Maintaining the appropriate duration exposure in bond portfolios, pursuing lower credit-
rated securities and migrating into high dividend-paying stocks offer life rather than death in bonds.
Banks must lay emphasis on investing in corporate bonds and the trading should also be increased.
Increased investment in corporate bonds has the following.

If the trading in corporate bonds is increased then it will make the market more liquid.
Enhanced liquidity in the market will lead to development of the market.
Banks return will be increased as the corporate bonds offer more interest compared to Govt.
bonds.
The focus must be to develop a vibrant corporate bond market in India as it will provide an alternative
platform for raising debt finance and reduce dependence on the banking system. Another benefit of
developing a liquid and vibrant corporate bond is that the corporates have to make additional
disclosures because if the corporate wants to raise capital from the market it has to make full
disclosures. Which is not there when a corporates borrow from the banks. Large borrowers should be
pushed to raise funds from the market, it will increase issuance over time and attract more investors,
which will also generate liquidity in the secondary market.
With Reserve Bank of Indias interest rate policy stance changing to neutral from accommodative, yields
will have stable to rising bias. Low duration strategy would help investors because of low price volatility
and accrual income generation.
The corporate bond exposure must be to good quality papers. The investment objective must be to
generate returns over short to medium term by investing predominantly in corporate debt instruments.
Currently, there is a possibility of rising interest rates. Low duration strategy would help on account of
low price volatility and accrual income generation. The current portfolio strategy would be to keep a
short average maturity, thereby limiting interest rate risk and may subject to change.
In such an environment, the portfolio must be positioned around lower duration spectrum with focus on
accrual as well as credit quality.
The banks should focus to create a portfolio of corporate bonds and money market to take advantage of
favorable yields present in the short end of the yield curve compared to the current repo rate of 6.25%.
As the maturity of the portfolio is lower, it would benefit investors in a rising interest rate scenario.

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References

www.livemint.com
www.financialexpress.com
www.hindubusinessline.com
The Handbook of Fixed Income Securities_Frank Fabozzi_7th-Ed.
FIMMDA valuation of bonds
Stress testing guidelines Rbi circular oct, 2017
Irrbb guidelines feb 2, 2017

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