Post-demonetisation, we saw yields for government securities fall sharply. Even though there was some retreat after the announcement of incremental cash reserve ration (CRR), government security (g-sec) yields seem set to fall further given the expectations of a rate cut. Unlike g-sec yields, which are primarily driven by interest rate trends, yields on corporate bonds are influenced by other fundamental factors as well. The difference in yields of two bonds issued by qualitatively different entities (here, g-secs and corporate bonds), but carrying a similar maturity, is referred to as the credit spread. If the spread between a corporate bond and its g-sec peer widens, it may indicate a higher risk attached to that bond. For investors in credit opportunities and corporate bond funds, it is worth considering if the risk can play out.
In the current situation, as g-sec yields fall, can we expect a similar trend in the corporate bond yields or are spreads likely to widen?
Can credit spreads widen?
The spread can change due to many reasons. One is, change in interest rates or inflation in an economy, which can impact the yield of government securities. The demand-supply dynamics of corporate bonds and the fundamentals that impact a particular industry, are also a factor. Currently, all these variables are changing a bit.
It may be too soon to talk about the widening of credit spread, but one can't ignore that certain sectors, specifically non-banking finance companies (NBFCs), real estate and gems and jewellery, can see an immediate negative impact on cash flows in the wake of demonetisation.
"There haven't been many trades in corporate bonds recently, hence, yields haven't changed much. The cash dependent sectors are more likely to see an increase in risk. If the macro impact is enduring and there is a slowdown, it can result in wider credit spreads for some sectors," said R. Sivakumar, head-fixed income, Axis Asset Management Co. Ltd.
If the liquidity condition in the economy takes longer than expected to normalise, the cash flow impact on some cash-dependent sectors can lead to concerns about short-term stability. It can also widen yields, resulting from higher premiums for issuances from sectors where risk is perceived to be higher.
Moreover, this uncertainty along with the forthcoming monetary policy review has meant that not many transactions are happening in the corporate bond market.
"The entire effect of the current situation will be known better post policy and post the event of CRR on 8 December. The market is range- bound, sellers are looking to exit post policy and buyers feel that 25-basis-point (bps) cut is already factored in, hence, the bid ask range has widened. While corporate bonds would remain in flavour but credit papers may be avoided because of liquidity concerns in these volatile markets," said Swati Singh, executive director, Avendus Wealth Management.
Expectations on inflation and interest rates have now changed, leading to a sharp change in market yields within the liquid part of the bond market. On the other hand, given that g-sec yields are extremely low now, with the 10-year in a range of 6.25-6.35%, the demand for higher-yielding corporate bonds could pick up. A pick-up in demand, if it happens, can also lead to narrowing of the credit spread.
What to watch out for
Even as the monetary policy outcome does not have a direct impact on the corporate bond yields, the uncertainty slows down transactions. "How the monetary policy impacts the bond market depends on the quantum of rate cuts already factored in versus what is announced. At the moment, the market seems to be pricing in around 25 bps repo rate cut in the upcoming policy and another 25 bps repo rate cut in February 2017," said Anil Bamboli, senior fund manager, fixed income, HDFC Asset Management Co. Ltd.
It is also important to keep track of how soon normalcy returns in the banking system. "On a relative basis, the risk premium in certain sectors has gone up. One has to now assess whether the issue is one of solvency or liquidity. At the moment, it seems more a liquidity issue. If companies have adequate capital or are able to borrow more, it is a temporary dislocation," said Pankaj Sharma, head-fixed income, DSP BlackRock Investment Managers.
If risk premium for segments like NBFCs and real estate increase, market yield of outstanding bonds will rise. If there is capital paucity and low ability to raise incremental capital, any dent thanks to demonetisation can have an impact on cash flows. Bamboli said, "If spreads do widen, it presents an opportunity as overall bias remains for softer rates. Each security will then get evaluated on merit to see if it fits the portfolio."
It is still too early to ascertain the cash flow impact that demonetisation has had on various sectors. Nevertheless, it is anticipated that some segments like NBFCs, companies with loan against property business, real estate and microfinance companies are likely to be affected more than others as their business is mostly dependent on cash. But the situation is likely to be temporary. If the worst-case scenario comes true, it is the funds with reasonable diversification that would be able to withstand this.
In arrangement with HT Syndication | MINT
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