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Investment in a type of bond derivative called forward rate agreements could likely rise in India as the interest rate cycle turns and the country's largest insurer enters the market, traders said.

Forward rate agreements (FRA) are contracts between banks and insurance firms that allow the latter to lock in rates for a future date, protecting them from volatility. Insurers entering such deals can offer guaranteed returns to policy holders.

Central banks globally and in India are poised to cut rates over coming months. Rising demand for debt via derivatives such as FRAs from insurance companies could lead to yields falling and help lower borrowing costs for the government.

We are already in talks with banks to start FRA trades in near future, Siddhartha Mohanty, Life Insurance Corporation's CEO, said in a media briefing last week.

The widening spreads between government bond yields and overnight indexed swaps (OIS) is aiding demand for such instruments, traders said.

Five-year OIS rate has crashed 30 bps since July 1, while yields for bonds maturing in 10 years and above dipped 4 bps-13 bps on rising U.S. rate cut bets.

"At the current level, we should be seeing more interest in FRAs," Vikas Jain, head of India fixed income, currencies and commodities at Bank of America said.

FRA trades worth around 113 billion rupees ($1.35 billion) took place between July 1 and August 2, up nearly 20% from 87 billion rupees in June, clearing house data showed. Traders are anticipating a further jump with LIC entering the market.

STEEPENING CURVE

There has also been increased demand for 'Separate Trading of Registered Interest and Principal of Securities (STRIPS)', traders said. These are bond instruments that dealers "strip" to sell the principal payment and coupon rates separately.

"We have seen a pick up in STRIP trades recently, as they are linked to the shape of the curve. If the curve is very flat, STRIP interest is not there, but as the curve has steepened, some interest is picking up," Bank of America's Jain said.

A larger fall in shorter-duration bond yields than yields at the long-end has led to steepening, making "STRIPs more attractive than before as STRIPs are now trading at parity or at slight premium to the spot rate," said Rahul Bhuskute, CIO at Bharti AXA Life Insurance.

Given the consistent growth in life insurers' flows, demand for FRAs and STRIPs would continue to be robust, especially given the seasonal pick up in insurance business in October-March, he added.

($1 = 83.9625 Indian rupees)