HDFC executes an unusual transaction to hedge its borrowings against interest rate risk

India’s biggest mortgage financier has used an unusual trade to hedge some of its loans against interest rate volatility as it seeks to expand its range of tools to manage risk, according to people familiar with the case.

Housing Development Finance Corp., the country’s largest issuer of rupee bonds this year, used a so-called total return swap to hedge interest rate risks on a debt issue that closed last month, reported said the people, asking not to be identified while discussing private arrangements. The lender mainly used overnight index swaps before, they said.

The change in hedging tools comes as markets are rocked by soaring policy rates, with the Reserve Bank of India having hiked 140 basis points since May to fight inflation. The central bank said last week it would do “whatever it takes” to ease price pressures, although some traders expected it to tone down its hawkish stance.

Under the interest rate derivative contract, banks bought easily tradable sovereign bonds in the name of the Mumbai-based financier on their cash books, and HDFC would pay the overnight Mibor rate and a spread to lenders, people said. The spread acted as a fee that HDFC paid to banks that had taken a bond position for the financier.

A representative for HDFC declined to comment. The lender’s reliance on overnight index swaps to manage interest rate risk had allowed traders to place bets in the market to account for upcoming HDFC hedges whenever it raised funds, which made it more expensive for the financier to buy protection, the people said.

The contract is called a total return swap because it allows the receiver to earn returns on the underlying asset, in this case sovereign bonds, without having to fund assets on its balance sheet.

With more than 40% of the financier’s $66 billion in borrowings coming from debt securities, managing the potential mismatch of returns between the variable rate loans it offers and the fixed rates it borrows from is vital to HDFC. The swap agreement makes liabilities and borrowing variable for HDFC, thereby protecting its lending margins.

This would help in the event of a decline in policy rates over the life of HDFC’s bonds. It is not known on which bond the mortgage financier had covered the interest rate risks.

HDFC raised 181.1 billion rupees ($2.3 billion) last month through three debt offerings. Of the total, Rs 40 billion was raised through notes maturing in March 2024 at 7.28% coupon, Rs 31.11 billion through bonds maturing in June 2027 at 7.77% and the rest through through a 10-year jumbo offer at 8%.

Not all Indian companies use the total return swap to hedge their interest rate risk. This is because some are not in the lending business, so there is no need to hedge risk, and no other shadow financiers in the country have a balance sheet close to HDFC’s.

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