RBI gives legs to bank rally by extending HTM holiday

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Imagine the time off given to you to recover from a bruise is coming to an end. You are gearing up for work only to be pleasantly surprised to find that your leave has been extended because the workplace, for reasons unknown, expects more accidents to befall you.

This in a nutshell explains the Reserve Bank of India’s (RBI) decision to continue to give protection to bond portfolios of banks from the impact of market movements.

On Wednesday, the RBI said that banks can hold bonds qualified under the statutory liquidity ratio (SLR) bought between September 2020 and March 2024 under the held-to-maturity (HTM) bucket up to the limit of 23 percent of net time and demand liabilities (NDTL). Simply put, banks won’t need to mark the prices of government bonds bought between the above period to market prices and account for the resulting losses.

Investors in bank stocks are already noticing this added boost to profitability, particularly for public sector banks. The Nifty PSU Bank index surged 3.8 percent on Thursday while the overall sector index gained more than 1 percent. As such, the rally in bank shares is expected to sustain given the optimistic outlook on credit growth and bad loans. Helping banks contain losses in the bond portfolio would be an added advantage.

Banks hold their bond investments in three buckets: HTM, held-for-trading (HFT) and available for sale (AFS). Investments held in HFT and AFS have to be marked to market prices and the profit or losses charged to the banks’ bottom line. The HTM bucket provides protection from mark-to-market hits as securities held in this bucket are deemed to be held until they mature.

During periods of elevated inflation and in rising interest rate cycles, bond yields tend to rise and prices tend to fall. Bond yields and prices move in opposite directions. This results in investors facing losses on their bond portfolio. Banks are captive investors in government bonds because of the mandate to maintain SLR which currently stands at 19.5 percent of deposits or NDTL.

When banks face an MTM hit on their bond investments, they end up booking treasury losses which in turn brings down their overall profitability. Recall that the largest lender State Bank of India (SBI) reported an unexpected quarterly loss for April-June this year due to a large MTM hit on its bond portfolio.

That said, in the current rising interest rate cycle so far, India’s banks have managed their trading books better than in previous rising interest rate cycles. In the July-September quarter, big lenders such as Bank of Baroda, ICICI Bank, Canara Bank, HDFC Bank, and even SBI were able to either contain losses or even avoid any MTM hit on their treasury books.

“It is debatable whether this dispensation was required this time. Most banks were able to manage their portfolio better. But we can anticipate that bond yields will rise in the coming year because government borrowing, policy tightening, and HTM rule make it easy for us to protect our investments,” said a treasury official at a public sector bank.

Since May this year, the RBI has hiked its policy repo rate by 225 basis points (bps). In reaction, the benchmark 10-year government bond yield has risen by a mere 16 bps so far. The movement in state bonds has been muted as well. However, short-term treasury bill yields have risen sharply, by about 200 bps. The hit on treasury, though, is likely to be limited.

The outlook on bond yields for the year ahead is uncertain. Some investors foresee a rise in yields as the government comes with its borrowing plan for FY24, which is expected to match the current year’s supply. Central bank tightening across the globe would mean the RBI cannot let up on its tightening either. The HTM extension would ensure that banks do not turn into persistent sellers of bonds.

“On the margin, we believe this is positive for bonds and allows banks to run with a higher proportion of bonds in their HTM. However, we feel this extra bank demand will be needed, especially in FY24, when we still see an elevated fiscal deficit,” analysts at Nomura wrote in a note.

Analysts believe that the HTM relaxation will help banks manage their bond investments as they start allocating more deposits toward lending. “The HTM dispensation will ensure there is no mark-to-market hit on banks now. This is only going to add to the profitability and hence the current rally in bank shares,” said Anand Dama, banking analyst at Emkay Global Financial Services Ltd.

India’s banks have had the best run in the equity markets this year with the sector index outperforming the broader market by a mile. It has been raising upgrades in earnings per share for most banks and brokerages have re-rated several large lenders.

For perspective, the Nifty Bank index has surged 19 percent so far in FY23 against a modest 5.5 percent rise in the Nifty 50. Public sector banks have latched on to the rally and have outdone their private sector peers in the past few months.