Uncertain bond market casts shadow on economy

The notion that the bond market will eventually replace bank loans is coming under scrutiny as yields rise, while banks keep their lending rates relatively unchanged.

The rate cycle has decisively changed to an uptick, as can be seen by the sharp reaction to any incremental adverse news flow. Investors are cutting losses, while the successive withdrawal of high-yielding quasi-equity bonds, which yielded returns of as high as 11-11.25 per cent, has caused further losses to investors, particularly mutual funds. Not only has the rise in bond yields caused banks mark-to-market losses in the December quarter and will affect their March quarter treasury profits, the cost of borrowing for corporates has risen. And to top it all, foreigners are liquidating their bond holding slowly. Since the incremental space for investment is limited for foreign investors, most of the ~6 trillion of borrowing in the next financial year will have to be borne by local investors, but compounding the problem here is that banks have become risk-averse and nobody knows when they will return to the market as major buyers.

Yields on the 10-year bond rose about 70 basis points in the December quarter, causing nominal losses of at least ~150 billion to banks. So far in the March quarter, yields have risen about 32 basis points, causing some more damage to bank treasury.

“It is uncertain times for the bond market. People keep changing their views about rates and the fact that banks have incurred losses due to an adverse yield movement and bad debts. It is clear that their risk appetite has been hit and nobody knows when they will come back in the market. It is no longer about the level anymore; it is a demand-supply issue, which is much more fundamental,” said Piyush Wadhwa, head of trading at IDFC Bank.

“The demand for long-end bonds is very low. And that is affecting corporates too. Even as spreads over gilts have narrowed, the cost has gone up,” Wadhwa said.

Pradeep Khanna, managing director and head of trading, Global Markets, HSBC India, said banks, insurance companies and mutual funds would have to come back to the bond market in the next financial year as the surplus bond holding was not much in excess of the mandatory requirement.

“However, unless there are new developments that cause a rethink on the interest rate environment, it is quite possible that demand from banks will be for shorter duration bonds while the government has planned to issue longer duration bonds in order to prevent unduly high maturities in the next few years,” said Khanna.

The criticism by Reserve Bank of India deputy governors about their risk management capabilities has clearly upset banks. And this has added to the risk aversion. At a time when yields in developed markets are also on the rise and central banks are talking about rate hikes, local yields are likely to rise.

In this context, things are not looking bright for the fixed income market.

Yields will probably rise further. Butbanks, forwantof better credit growth, will still be going slow in raising their lending rates, even as the RBI will continue with its pause for a few months. This raises the question then, are wellratedcorporatesstillbetteroff raising money from the bond market? They may not have any option in today’s narrowbanking environment.

Prabal Banerjee, group finance director at the Bajaj Group, maintains that for lower-rated firms there is no other avenue but to borrow from banks. But banks until a few months ago were willing to lend to better-rated firms. Now that has collapsed.

“Unless the corporate is of the highest credit quality, banks are just not willing to issue loans. And this situation will continue for a few years. Companies will have to tap the bond market for funds,” said Banerjee.

Here, the cost has risen substantially. For example, an AAA-rated firm can raise 10-year bonds at 8.35 per cent, up about 50 basis points in six months time, even as spreads over the 10year gilt has contracted from the normal 75 basis points to 50 basis points.

“While it is true that bank lending rates have moved up significantly less than bond yields, we believe that for AAA-rated corporates it may still be cheaper to access funding via the bond market. This may not hold true for lower-rated corporates,” said Khanna of HSBC.

The rising yield is also not good for mutual funds. Even as the industry protects itself by buying at every level, and thus averaging out, assets under management have seen some contraction in recent times for some mutual fund houses.

“The current interest rate trajectory is a litmus test for bond market participants, ideally this should provide a good perspective on the sustainability of rising reliance on debt products over conventional bank deposits, the surge in bond issuances and broadening of the bond investor class. Seasoning of participants is essential for the development of financial markets, especially in an environment of rising external linkages,” said Soumyajit Niyogi, associate director of India Ratings and Research.

AccordingtoCareRatings, with the government and RBI focusing on better use of the corporate debt market, there will be some shift in the preferences of borrowers.

“More importantly, with interest rate transmission being better in the market, companies too may prefer to use this mode of finance. However, it also looks likely that the interest rate trajectory for 2018 will only be upwards as it is expected that the RBI may hike rates during the course of the year. This could tilt the preference in favour of banks,” said Madan Sabnavis, chief economist, and Manisha Sachdeva, associate economist, at Care Ratings, in a report.

The issuance of corporate bonds has fallen in this financial year. Between April 2017 and January 2018, companies raised ~4.24 trillion through bonds, compared with ~4.52 trillion in 2016-17, Care Ratings said.

Bond investors are also upset at the recalling of additional tier 1 (AT1) bonds by banks.

Four banks so far have recalled ~104 billion of their AT1 bonds and more will follow. The repurchase follows a government diktat meant for banks undergoing prompt corrective action (PCA) of the RBI, and other banks could also recall the remaining ~98 billion in such bonds.

Overall, 11 banks are undergoing the PCA, of which nine had issued such bonds. Among these banks, the total AT1 issuance was about ~202.9 billion. The worrying fact is that five or six other banks may also fall in the RBI’s PCA framework. The recall, in that case, will again be substantial. The total size of AT1 bonds in the local market is ~761.4 billion, including issuance by private sector banks.

Why this should worry is that these bonds were bought heavily by mutual funds, sometimes at a premium from the secondary market. Now the bonds will be redeemed at par. Bond yields are likely to inch up as chances of interest rate cuts recede. In the last three years, the RBI had cut rates by nearly 200 basis points before entering the current pause period. Fund managers feel the pause period will be extended and interest rates are likely to be hiked going forward, putting pressure on bond prices.