By Anil Varma — November 26, 2008 05:31 EST

Nov. 26 (Bloomberg) — Indias government bond yields have never been higher in relation to interest-rate swap rates, prompting HDFC Bank Ltd.. Standard Chartered Plc and Sundaram BNP Paribas Asset Management Co. to bet the gap will narrow.

The cost to receive floating-rate payments for five years is 1.41 percentage points below similar-maturity government bond yields on speculation the central bank will keep cutting interest rates to support a slowing economy. Reserve Bank of India Governor Duvvuri Subbarao lowered benchmark rates twice since Oct. 20, taking advantage of cooling inflation.

«The record bond-swap spread is quite a bounty, said Ashish Vaidya. head of interest-rate trading in Mumbai at HDFC Bank, Indias third-biggest by market value. «It shows the market believes rates should be much lower than current levels, given the prospects for growth and inflation.

The recommendations show investors are preparing for a series of RBI rate cuts after Finance Minister Palaniappan Chidambaram said this week a further moderation in price gains may lead to lower borrowing costs. The International Monetary Fund forecasts Indias economic growth will slow to 6.3 percent in 2009, the least since 2003. Goldman Sachs Group Inc. predicts 2.5 percentage points in rate reductions by mid-2009.

In an interest-rate swap, two parties agree to exchange payments over a period of time. Typically, one will agree to pay a fixed rate, while the other pays a rate that fluctuates with a benchmark index or formula defined in the contract.

Record Spread

Investors can earn the difference between the rates by buying five-year bonds and agreeing to pay the fixed swap rate. The spread almost quadrupled this quarter, widening to a record 1.65 percentage points on Nov. 21 from 42 basis points on Sept. 30 as swap rates fell faster than bond yields. The five-year swap rate slid 2.5 percentage points this quarter, beating the 1.53 percentage-point decline in yields.

Bond yields lagged behind the slide because the cash required to buy debt dwindled amid the global credit crunch, while investors need less capital to use derivatives to speculate on Indias policy response to the crisis.

The cost of interbank overnight loans soared to a 19-month high of 20 percent on Oct. 31 even as the central bank cut its benchmark rate to 7.5 percent from 9 percent in two weeks. Goldman Sachs and JPMorgan & Chase Co. forecast more rate cuts.

Lowest Since 2004

Benchmark five-year government bonds yielded 7.14 percent in Mumbai today, while the comparable swap rate was 5.73 percent, near the lowest level since June 2004. The difference between the rates will shrink to 70 basis points in two months, according to HDFC Bank. Standard Chartered predicts it will fall to 50 basis points in three months. A basis point is 0.01 percentage point.

Investors should raise money-market loans to buy bonds and separately enter swaps to receive a floating rate similar to that paid on their borrowings, according to HDFC and Standard Chartered. Adjustable-rate payments from the derivative contract would meet the cost of the loans, leaving the fixed swap rate as the trades net expense. Any premium yielded over that by the bonds purchased is profit.

«Swaps have priced in steeper rate cuts than bonds, said Arvind Sampath. head of interest-rate trading at Standard Chartered in Mumbai. «As and when rates are lowered, bonds will catch up. That will reduce the bond-swap spread.

The daily bond trading volume in Mumbai totaled 99 billion rupees ($1.98 billion) yesterday, exceeding the 15.2 billion rupees in swap transactions, according to data from the Clearing Corp. of India.

`Debt Supply

Bond yields will fall faster that swap rates in the coming weeks also as government debt sales decline, he said.

«The scheduled government debt supply for the year is almost over, Sampath said. «That leaves more room for buying existing securities and pushing yields lower.

India has so far raised 1.45 trillion rupees ($29.3 billion) from bond sales in the fiscal year that started April 1, meeting its budget target.

India may fail to meet its budget deficit target for the fiscal year ending March 31 because of the global crisis that has forced the nation to borrow and spend more, Chidambaram said on Oct. 22. The government will exceed its borrowing target for the first time in four years, he said.

Slowing inflation and lower oil prices have stoked speculation Indias central bank will cut rates again, said Krish Ramkumar. who manages the equivalent of $1 billion in Indian debt at Sundaram BNP Paribas Asset Management in Mumbai.

Indias inflation rate fell to a five-month low of 8.9 percent in the week ended Nov. 8, the government said Nov. 20. Crude oil in New York has dropped more than 65 percent from a record high of $147.27 a barrel reached in July.

«Slower growth and easing inflation, thats the perfect recipe for interest-rate cuts, Standard Chartereds Sampath said.

To contact the reporters on this story: Anil Varma in Mumbai at avarma3@bloomberg.net.

To contact the editor responsible for this story: Sandy Hendry at shendry@bloomberg.net