Banks turn to long-term floating-ratedebt to hedge against rate volatility

KARACHI: Banks increased their investments in long-term local currency bonds in the second quarter of 2023, with most of them opting for floating-rate instruments to hedge against a potential rise in interest rates, data from a local brokerage showed on Saturday.

The bank’s investment strategy saw a major shift from short-term to medium- to long-term securities in June, taking advantage of rising interest rates and helping the state finance its fiscal deficit.

"The mix of holdings in gov’t securities show increased exposure of banks and insurance companies in PIBs (expected to be floaters mostly), while funds and corporates remained mostly invested in MTBs, as at June 2023,” said Arif Habib Limited, a Karachi-based brokerage house.

The central bank raised its benchmark interest rate by 100 basis points to record 22 percent at an emergency meeting on Juen 26.

The data showed, at the end of June, banks had outstanding investments in Pakistan Investment Bonds of Rs12.430 trillion, up 39 percent over the same period last year. Sixty percent of the overall PIB investments were made by banks. But during the same period, banks invested Rs5.510 trillion in Market Treasury Bills, a 5 percent decrease from a year earlier. Twenty six percent of all bank investments in government securities were made in T-bills. Sukuk (Islamic bonds) investments increased by 37 percent to Rs2.931 trillion.

The total amount of funds invested by banks in government papers rose by 24 percent to Rs20.870 trillion.

Insurance companies invested Rs1.275 trillion in PIBs as of June 30, an increase of 9 percent from a year earlier. These companies also invested Rs313 billion in T-bills, a rise of 56 percent from the year before.

In the latest T-bill and PIB auctions, the yield on three-month T-bills was 22.78 percent, while the yield on three-year PIBs was 19.34 percent.

The growth in demand for these floating-rate securities has resulted in higher yields, which has raised the government’s interest costs. To find a balance between luring in investments and upholding budgetary prudence, the government must carefully manage its borrowing strategy.

The move into medium-term securities also reveals how the market has responded to the current interest rate environment. The fact that investors appear to be looking for stability and predictability in their investments may be a sign that they are being cautious about the direction the economy will take in the future.

The State Bank of Pakistan left the policy rate unchanged at 22 percent in its meeting on September 14. It has hiked interest rates by a cumulative 15 percentage points to 22 percent since September 2021.

“So the mix has not changed on a total basis, but between different financial institutions it has changed,” said Fahad Rauf, the head of research at Ismail Iqbal Securities.

“The point to focus is a large amount is being borrowed in floating instruments (MTBs and floating rate PIBs) which has made the fiscal account unsustainable as we are in a high-interest rate environment,” Rauf said.

The core problem behind this is the government’s unending borrowing need, which is mostly being funded through open market operations (OMOs) by SBP. “The government needs to fix fiscal account by increasing the revenue side, which would result in less pressure on auctions and reduce the borrowing cost for government,” he added.

Data shows that the funds invested Rs979 billion in PIBs, which is 58 percent more than they did at the end of June 2022 when they invested Rs619 billion. The amount invested by funds in T-bills increased by 383 percent to Rs922 billion. Corporate investments in T-bills grew by 219 percent to Rs3.255 trillion, while their investments in PIBs increased by 80 percent to Rs1.544 trillion.

Because they can benefit from repricing during increased interest rates, the majority of banks have substantial investments in PIB floaters. In the non-banking sector, the insurance industry appears to invest in the PIBs floaters, according to Sana Tawfik an analyst and economist at Arif Habib Limited

However, corporations and funds mostly invested in T-bills, she said.

The government heavily relied on domestic sources to cover the budget deficit amidst a lack of external financing; hence a significant sum was raised through floating rate PIBs, she said.

Participants (mainly banks) who believe rates have peaked will build their fixed-rate PIB books because participation in fixed-rate PIBs was seen in the previous auction. Although the majority appears to still be interested in floaters, some investors have begun switching to fixed-rate PIBs, according to Tawfik.