Rising bond yields a risk to profits
Rising inflation and higher input costs are not the only risks to corporate earnings in the forthcoming quarters. India Inc finances also face a threat from the rise in interest rate in recent months as indicated by the yield on the 10year Government of India bond.
The yield on the 10-year government bond is up 46 basis points from the record low (quarterly average) of 5.9 per cent in the December 2020 quarter (Q3FY21) and continues to inch up. The bond market closed with a yield of 6.37 per cent on Friday, up nearly 16 basis points from 6.21 per cent on average in Q2FY22.
This, analysts say, can dampen corporate earnings in the forthcoming quarters as interest rates on most corporate borrowings are linked to the bond yield, directly or indirectly.
“A sharp decline in bond yields and interest rate last year provided tailwinds to corporate earnings. This is now tapering as bonds rise, which will soon start reflecting in funding cost for companies,” says Dhananjay Sinha, MD & chief strategist JM Financial Institutional Equity.
Historically, there is a negative correlation between the bond yield and India Inc’s interest cost. For example, there has been a steady decline in companies' interest burden over the past five quarters after the Reserve Bank of India (RBI) cut its policy rate in May last year, leading to a sharp decline in bond yields. However, it works with a lag of a few quarters.
For example, the quarterly interest payment by listed companies declined from a record high of ~2.78 trillion in the April-june 20 quarter (Q1FY21) to a 10-quarter low of ~2.48 trillion in Q2FY22. This translated into cumulative savings of ~1.15 trillion for listed companies over the past five quarters. This resulted in much faster growth in profit before tax and profit after tax than the underlying rise in operating profit or Ebitda in the period.
The analysis is based on quarterly results of a constant sample of 2,594 companies across sectors.
Analysts say that while part of the decline in interest cost came from corporate deleveraging, most of it came from a fall in borrowing costs.
As a result, companies' interest cost as a proportion of companies’ net sales declined to a five-year low of 10.4 per cent in Q2FY22 from 13.4 per cent in Q4FY20.
While the decline in interest rate benefited companies across sectors, the biggest beneficiaries were banks and non-banking financial companies.
For example, banks' cost of funds declined to a record low of 3.84 per cent in H1FY22 from 5 per cent in Q4FY20. This allowed banks to improve their margins or spread despite a cut in interest on loans and tepid credit growth over the past one and half years. These gains are likely to reverse in the next few quarters as lenders' cost of funds rises due to higher bond yields.
Others, however, don't foresee any material change in corporate borrowing costs in the forthcoming quarters. “What matters most for companies are the changes in yields on bonds with tenure of 3 to 7 years. There has been only a small rise in yields on these bonds unlike 10-year bonds,” says Shailendra Kumar, CIO Narnolia Securities.
Some analysts also expect a slight moderation in interest rate from the current level, thanks to the recent decline in oil and metal prices. “Crude oil prices have crashed 15 per cent in the past week while industrial metal prices are down 8-10 per cent. This is likely to dampen inflation which will put pressure on the interest rate,” says G Chokkalingam, founder & MD Equinomics Research & Advisory Services.
The decline in commodity price is also expected to ease the pressure on the RBI to raise the interest rate to cool down inflation in the economy. However, most analysts agree that even if bond yields stay at current levels for some time, India Inc can no longer rely on lower borrowing costs to propel their earnings. This will align earnings to volume and revenue growth.